WHAT COUNTS AS AN ALTERNATIVE investment? Opinions differ. But the list might include gold, silver, stocks of mining companies that focus on these two metals, hedge funds, mutual funds that endeavor to act like hedge funds, timber, farmland, private equity funds that buy privately held companies, residential and commercial rental properties, real estate investment trusts, commodity funds that buy everything from agriculture to energy futures contracts, stocks of energy and natural-resource companies, venture capital funds that invest in startup companies, and even bitcoin.
These various investments have one thing in common: They hold out the promise of performing well when stocks are getting crushed. Or, to use Wall Street lingo, these are potentially uncorrelated assets. That’s a valuable quality. If you own something that rises in value when stocks fall, not only will you find investing less nerve-racking, but also you could turn this lack of correlation into additional investment gains through regular rebalancing.
Keep five caveats in mind. First, past correlations can be a lousy guide to future correlations. Take commodity futures. These are now widely owned by investors. As a result, not only are long-run returns from commodity-futures funds likely to be lower than history suggests, but also they are more likely to rise and fall with the same overall investor sentiment that drives stock returns.
Second, in some cases, the diversification benefit may be an illusion. For instance, timber is seen by some institutional investors as a great way to diversify financial assets like stocks and bonds. But the apparent lack of correlation may simply reflect the absence of daily price information on your 1,000 acres of timber.
Third, many of these alternative investments come with steep investment costs. Hedge funds are the most notable culprit, though mutual funds that employ hedge-fund-like strategies are also far from cheap.
Fourth, some alternative investments can’t be quickly sold, including rental properties, hedge funds and venture capital funds. That lack of liquidity makes rebalancing difficult.
Finally, never forget that low correlation is a double-edged sword. It may help when stocks are falling, but you could find yourself disappointed by your alternative investments as they tumble in value while stocks roar ahead.
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