How Commodities and Other Alternative Investments Can Help Diversify Portfolios

Democracy as commonly defined is based on government “by the people,” at least in theory (and what we remember from high school civics class). We can look at today’s markets through a similar lens, more specifically on the subject of alternative investments and portfolio diversification.

Alternative investments, or “alts,” in some ways represent expanding “democratization” of our markets, where most everyone has a voice or opportunity to vote. Alternative investments take many forms, including commodities, managed futures, hedge funds, private equity, and other vehicles that historically were the exclusive realm of sophisticated, deep-pocketed investment professionals. That all changed in recent decades as the growth of exchange-traded funds (ETFs) and other, similar assets presented individual investors with opportunities to get a foot in the door of the alternatives club.

Ready to dive into alts? Hold on a sec—alternative investments can be a handy tool for portfolio diversification, but compared to traditional stocks and bonds, alts are a different kind of animal, so it’s important for investors to understand how alternatives work and their unique risks. Here are a few key points.

Define Alternative Investments: How Do They Differ from Traditional Stocks and Bonds?

In the 1980s and ’90s, “alternative” became a trendy marketing tag for a certain genre of rock music. But as definitions, perceptions, and tastes shifted, the word grew increasingly squishy—an eye-of-the-beholder term meaning different things to different people. In investing, it’s a good idea to apply similarly critical thinking toward alternative investments. Is a given investment truly “alternative” or more “mainstream?”

Defined broadly, alternative investments reside outside of traditional stocks, bonds, and cash. Alts don’t fit neatly into conventional investing categories and may not be available on established exchanges like NASDAQ or NYSE. In addition to commodity futures, managed futures, and private equity, other forms of alternative investments include real estate, real estate investment trusts (REITs), and venture capital funds. 

How Can Alternative Investments Potentially Provide Portfolio Diversification Opportunities?

In a few words, it’s about correlation, or more precisely, lack of correlation. Alternative investments can be appealing because these assets are supposed to be uncorrelated, or minimally correlated, with stocks and bonds. When stocks in your portfolio zig, alternative investments zag—or at least that’s the idea.

The potential noncorrelation to stocks and bonds is one reason alternative investments can help diversify your portfolio and add a potential buffer against broader market turmoil. Investors building a diversified portfolio typically aim to have positions as uncorrelated as possible from one another, so everything isn’t moving in the same direction all the time. When one asset class is going down in price, another asset class is going up.

What Types of Alternative Investments Are Available?

In commodity futures, categories include energy (such as crude oil and natural gas), industrial and precious metals (copper, gold, silver, and others), and agriculture (corn and soybeans, for example). These commodity markets are linked to established, relatively actively traded futures contracts with a wide following in the financial media.

To get commodity exposure, the retail crowd often turns to commodity-based ETFs. According to ETF.com (an ETF data and news subsidiary of Cboe Global Markets), as of June 2020, there are 137 different commodity ETFs, with total invested assets of $121 billion. Some of these funds invest in physical commodities and others use futures contracts to try to mirror the return profile of a commodity or commodity index benchmark.

Some advanced traders do it on their own—trading commodity futures and options contracts outright. There are also managed futures funds, in which a licensed Commodity Trading Advisor oversees a portfolio of futures positions. 

Beyond the listed market, some investors turn to real estate for alternative exposure. Others look to collectibles—works of art, fine wine, antiques, classic cars—when seeking investments that may be noncorrelated to traditional investments.

How Have Commodity Investments Fared Historically Compared to the Broader Market?

Though managed futures isn’t necessarily a perfect proxy for commodity investing, research there could shed some light on how alternatives might provide a safer port during broader market storms.

For example, during the fourth quarter of 1987, which brought the “Black Monday” market crash, the S&P 500 Total Return Index fell more than 22%. By contrast, the Barclay BTOP 50 Index, which tracks the performance of managed futures funds, rose nearly 17%, according to a 2014 report by futures exchange operator CME Group. During the first quarter of 2009, as the previous year’s credit crisis continued to roil markets, the S&P 500 Total Return Index declined 11% while the BTOP index fell just 1.8%.

On the flip side: More recently, as U.S. markets repeatedly marched to record highs, managed futures appear to have underperformed major benchmarks. In 2019, the S&P 500 Index gained 29%, while the BTOP index rose 6.7%.

How Much Exposure to Alternative Investments Is Appropriate for Individual Investors?

To what extent, if any, alternative investments should be part of a portfolio depends largely on an investor’s risk tolerance and time horizon. It’s important to understand that managed futures and other alternative investments should be viewed as a potential complement to a broader portfolio. Individual investors might consider allocating 5% to 15% of their total portfolio to alts as a ballpark target range. Of course, that decision should be based the individual investor’s goals and risk tolerance.

What Are the Risks and Other Important Need-to-Knows About Alternative Investments?

Alternative investments are not appropriate for everyone. Investors should approach alternative assets with eyes wide open and make sure they educate themselves on the risks, asset structures, and other factors. Alternative investments are often less liquid than stocks and bonds, can be more difficult to value, and may come with complex or opaque ownership structures. Some alternative investments, such as hedge funds, may require minimum investment levels that can be higher than other assets.

For hedge funds, these minimums could be in the millions of dollars, although recent years have seen the launch of ETFs and mutual funds that try to mirror the style and tactics of hedge funds and don’t require as large of an investment.

Alternative investments that use futures contracts also pose certain wrinkles. All futures contracts expire, meaning a futures portfolio must be carefully managed over time to “roll” positions from one month to the next to maintain the desired exposure to the commodity. Be mindful that rolling futures positions can amplify or erode returns. For any futures-based ETF, it’s also a good idea to investigate the track record of the fund manager and how they’re addressing their exposure to certain markets.