Where Is The Hedge?

Alternative investments aren't meant to replace core holdings, only to augment them.

It hasn’t been a great year for alternative investments. To put it simply, vanilla trumped spice. Only one alternative class—real estate—beat the S&P 500 Index in 2014. Of course, alternatives, or “alts,” aren’t meant to replace core holdings, only to augment them.

And unless you’re adding new money to your portfolio, you can’t just drop in a slug of alts. You typically make room for such investments by reducing other allocations. Yes, a dollop of real estate might have boosted your returns over the past year, but at what cost?

Alternative investments aren't meant to replace core holdings, only to augment them.

Let’s put this in real-world terms. The one-year return of the PowerShares Active US Real Estate ETF (NYSE Arca: PSR) is nearly three times that of the SPDR S&P 500 ETF (NYSE Arca: SPY). Better still, PSR earned its outsized gain with less volatility than the blue chip portfolio. Did that make real estate your best alternative bet last year? Well, maybe. It really depends on your definition of “best.”

To see what I mean, let’s look at an array of liquid alts—exchange-traded funds pursuing hedge fund or non-traditional strategies. In addition to the PSR portfolio, the other tactics are exemplified by:

Let’s now gauge these alt funds against two core holdings: the SPY fund mentioned above and the iShares Core US Aggregate Bond (NYSE Arca: AGG), a compendium of debt securities that includes U.S. Treasury and agency notes, corporate bonds, and mortgage-backed and other asset-backed paper.

Four funds in Table 1 stand out for their negative correlations to SPY. One, AGG, is a core holding. Seemingly only three of our alt funds provided the much-vaunted “hedge” against domestic cap-weighted equities. One is a perennial—GLD, representing gold bullion. The other two are equity funds. RALS earns its mildly negative coefficient because of its long/short admixture of stock exposures. The most significantly uncorrelated asset was the short-only HDGE portfolio.

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DisclosureBrad Zigler pens Wealthmanagement.com's Alternative Insights newsletter. Formerly, he headed up marketing and research for the Pacific Exchange's (now NYSE Arca) ...

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