The term “alternative investments” may conjure images of classic automobiles, fine wine, rare art and valuable jewels. Some may think about the Honus Wagner baseball card that sold for $3.12 million at auction in 2016. Or about the 1962 Ferrari 250 GTO that sold at auction for a whopping $34.65 million in 2014. Or maybe they set their sights even higher and think about the Hope Diamond, with an estimated value of $200-$250 million.
While these treasures are fun to picture, they would not be permissible or practical investments within a retirement plan. So what exactly is an alternative investment in this context? A simple way to comprehend these investments is right in their name—alternative—they are not conventional investment types, e.g. stocks, bonds and cash. Alternative investments include private equity, hedge funds, managed futures, real estate, commodities and derivatives contracts.
Alternative investments, like REITs (real estate investment trusts) and Commodities, have their place in a well-managed portfolio within proper asset allocation parameters and with regular oversight. The danger is when participants misuse and/or don’t fully understand this asset class. Alternative investments can be difficult to valuate and can be subject to enhanced volatility. Consider the most recent financial crisis. In the aftermath of global equity markets plummeting, some investors sought safe haven in gold which buoyed its price to record levels. As a result, some plan participants observed this phenomenon and were swayed to reallocate some, or even all, of their retirement plan assets there.
Subsequently, along with the meteoric rise in the price of gold, came a decline. Gold peaked at $1,920.70 in August 23, 2011 and fell to $1,048.30 by December 17, 2015.¹ An investor who bought at the high and sold at the low, realized a loss of 45.4 percent over this time period. A $100,000 investment would have fallen to $54,579. Let’s contrast that with a diversified portfolio with its foundation in core asset classes and only a portion allocated to alternatives. Consider a hypothetical portfolio allocated as follows: 40% U.S. Equity, 10% International Equity, 40% Core Fixed Income, 5% Commodities, and 5% Global REITs.¹ Over the same time period, this portfolio achieved a positive return of 46.48 percent. So a $100,000 investment would have grown to $146,480.
A broader stand-alone Commodities fund would have proven just as dangerous. Commodities (as measured by the Bloomberg Commodity Index) produced a negative return every year between 2011 and 2015, for five consecutive years. Annualized five-year returns in Commodities were negative 10.27 percent.¹ This means a $100,000 investment would have fallen to $58,169 during this time period. Again, if an investor instead used a diversified portfolio during this time period they would have achieved annualized returns of 7.62 percent, turning the original investment into $144,366. Again resulting in a much better outcome in the diversified portfolio.
Under both scenarios, participants would have been disappointed had they invested their retirement plan assets exclusively in alternative investments. As seen in the examples above, if these were just portions of a well-diversified portfolio, the effects could have been minimal. Some exposure could have been helpful in 2016, with Commodities finally turning the corner and returning almost 12 percent and Gold up almost 8 percent.¹
While alternative investments can perform well and occasionally produce great returns, you may want to think twice about using them as stand-alone investment options in a retirement plan. Risk/reward optimization can be maximized within the confines of a well-constructed asset allocation, such as a target date fund. These funds are professionally managed, rebalanced and enjoy constant oversight to appropriate asset allocation across various asset classes.