By Rajat Wadhwani, CFA, SVP, Bank of America

For many of us, the common thoughts that accompany "alternative investments" are volatility, speculation, and high cost. We are torn between the desire for high returns on one hand and preserving and growing our wealth on the other hand. We become victims of fear and ignorance. In the process, we may miss opportunities to earn extra returns to our portfolio while still managing risk.

Alternative Investments is a term given to investments that are not main stream investments such as traded stocks, bonds, Treasury, and Certificates of Deposit(CDs). As these alternative investments become popular and get a mass following, they tend to join main stream. Included in this asset class are investments such private equity, hedge funds, commodities, and real estate. These investments often lack liquidity, and have a very long term horizon. Also, these tend to be black-box investments with limited access to performance and investment information. These investments are not regulated by SEC.

Alternative Investment Returns

The excess return from alternative investments in any portfolio come from -- (a) Valuation inefficiencies, because these investments are not from main stream; (b) Lack of high positive correlation with other asset class such as stocks and bonds, a desirable attribute for portfolio diversification; and (c) Excess value creation from giving up liquidity.

Per Se, alterative investments carry very high risks and constitute a volatile asset class, unless these are taken in a context of a portfolio. In that case, these assets tend to mitigate portfolio risk because these investments frequently have lower correlation (and sometimes negative) with publicly traded securities.

Diversifying the Portfolio

These investments provide much needed diversification to what may be considered a well balanced and diversified portfolio of stocks and bonds. However, given the individual characteristic of this asset class, only a small portion of portfolio needs to be allocated to alternative investments. In isolation these investments can result in loss of principal, may have restrictions on transfer, may exhibit high volatility of returns, lack transparency in valuation and can have high management costs.

Alternative investments have found place in Pension and Endowment funds as their portfolios can exploit the aforementioned attributes of this asset class due to their size and longevity. It is well known that Endowment funds such as Harvard and Yale have managed to significantly outperform the benchmarks over 10, 20 & 30 year period.

Financial Advisors and Alternative Investments

For individuals, investing in alternative investments is tricky. Financial advisors tend to avoid this asset class due to lack of enough proxies among main stream investments, lack of client education, and the transparency and liquidity desired by the client. However, a little effort in educating their clients, can lead to inclusion of this asset class in individual portfolios creating a truly diversified portfolio, and improving long term risk adjusted portfolio performance.

Individual portfolios differ from Pension & Endowment funds. The latter are often very large and having extremely long investment horizons, can afford investments that carry restrictions and have low to no liquidity, and can manage the high management cost by sheer economy of scale.

Investing in Private Equity

Individuals can include this asset class in their portfolios by including proxies such as REITS, commodity funds as well as special Exchange Traded Funds(ETFs). Two interesting ETFs to get exposure to Private Equity are PowerShares Listed Private Equity Portfolio ETF (Ticker: PSP), which invests in companies with direct investments in more than 1,000 private businesses, or iShares S&P Listed Private Equity ETF listed on London Stock Exchange that offers exposure to shares of about 25 of the world's largest publicly traded private equity stocks. These funds provide diversified exposure to the private equity universe, traditionally a difficult-to-access alternative asset class.

Other opportunities to get exposure to alternative investments are stock of companies that are engaged in private equity or operate as one. Some names include Goldman Sachs(GS), Sears Holding(SHLD), and Berkshire Hathaway(BRK). Beyond the listed securities that act as proxy to alternative investment asset class, one could get direct exposure to private equity, through Master Limited Partnership (MLPs) that invest in assets such as Timber and Energy, some of which get listed, and direct investments in hedge funds. Most direct investments in private equity and hedge funds require a large minimum investment.

Diversification may be the only free lunch in investing. While alternative investments do provide the requisite diversification, the excess returns from these investments come at the cost of giving up liquidity and transparency. For individuals, the life of the portfolio is not infinite, unless, the wealth is bequeathed to a trust that has objectives that mimic those of an endowment fund. Hence, in a given lifespan, the age of 35-45 is the "Golden Age for Investing".

Alternative Investments and Your Life Cycle

During this age, one enters into a phase of rising incomes, enjoy good health, and have likely overcome the indulgence from 20s and early 30s having established a fiscal discipline. One also has more discretion on investments because the retirement is still 20-25 years away. The 20-25 year horizon is the biggest tool in the arsenal because historically, even in worst of declines, all asset classes have always had a positive return over 20 year period. For these reasons, the "Golden Age of Investing" is also the best time to allocate a larger percentage of your portfolio to alternative investments.

Alternative Investments belong in a balanced diversified portfolio with long term objectives such as savings for retirement. The allocation of alternative investment as a percentage of portfolios would vary with the stage in Life Cycle and overall portfolio objectives. Exposure to this asset class can be made via tradable securities that act as proxies or through direct investment. Investment decisions in alternative investments should be made in consultation with a financial advisor who is aware of client's Investment objectives and client's current portfolio.