Does your portfolio need alternative investments?

Alternative investments are a little like alternative music: Ask 10 people what they are and you'll get 10 different answers. Simply put, alternative investments are anything that aren't mainstream. So they won't be stocks, bonds, or money market funds.

For hedge funds and huge endowments like those found at Harvard and Yale, alternative investments include private equity and other illiquid investments. Among mutual funds, Morningstar lists no fewer than seven alternative fund categories, with names such as Multicurrency, Long/Short Equity, and Bear Market. Most of those funds, though, are also exotic playthings for institutional investors.

None of the categories include what many financial advisers consider alternative investments for mere middle-class mortals, such as commodities, real estate investment trusts (REITs), and perhaps absolute return funds, which can use techniques such as short selling and investing in options and derivatives to generate returns.

Read about an alternative approach to investing that has nothing to do with alternatives, and visit our Investing Center. 

Yet alternatives are increasingly considered essential for some investors. Three out of four financial advisers use them in the portfolios of at least some of their clients, though usually for a small fraction of the portfolio—one-fifth or less. The primary reasons for including them are perhaps familiar if you've ever picked up marketing material for those investments: Alternatives offer greater diversification than a typical portfolio, they help manage risk, and they reduce volatility. They do all that to generate superior returns.

But is that really the case? We can't pretend to be able to cover each animal in the alternative investment menagerie, but a representative example illustrates what alternative investments can, and cannot, do for your portfolio.

One reason for investing in alternatives is diversification, the cornerstone of modern portfolio theory that hypothesizes that a collection of diverse investment assets offers greater return while simultaneously reducing risk. More return and less risk is why diversification is often referred to as the only free lunch in investing. The idea is that as one asset zigs, another zags.

The theory even applies to a portfolio that is made up of only two asset classes, such as stocks and bonds. Many target-date funds, the all-in-one solutions found in most workplace savings plans, are composed exclusively of those two asset classes, because the managers of the target-date fund believe that a portfolio with both has the best chance of appreciating, while also minimizing any potential interim losses.

But will adding additional asset classes to a portfolio, such as alternatives, produce even better results? It's a question worth asking when you consider that the costs of alternative investments are generally higher than their bread-and-butter stock and bond counterparts. Even exchange-traded funds, which are generally the cheapest approach to gaining exposure to alternatives, often have expense ratios of at least 0.70 percent annually, twice that of most domestic stock and bond index ETFs.

Chalk it up to bad timing, but there is a good argument that adding alternatives to your portfolio won't help much with generating higher returns—at least these days. Over the past few years, many alternative funds were unable to deliver returns that were any better than less diversified funds. In 2012, for example, though stocks and bonds generally performed well, returning 16 percent and 4 percent for the year, respectively, more than half of the absolute return funds lost money.

Anyone who has read a fund prospectus is familiar with the phrase "Past performance is not a guarantee of future returns." With alternatives, there's a new twist on that phrase in some marketing material: "Past correlations do not guarantee future correlations."

The idea behind correlation is to measure whether two investments move in the same direction. A correlation of 1 indicates that the two investments are perfectly correlated, or moving in sync with each other. A correlation of minus 1 indicates that they move in opposite directions. If the correlation is zero, the two investments move independently of each other.

In the past alternatives were largely uncorrelated, sometimes outperforming stocks and bonds, giving a boost to portfolios when stocks, for example, were down. More recently, alternatives have been more closely correlated to stocks, partly explaining why many alternative funds haven't performed as advertised. From 1990 through 2008, for example, commodities, considered by many to be the alternative investment having least in common with mainstream stock and bond investments, had zero correlation with stocks. But since 2008, the correlation increased—to 0.5—so although they're not moving in lockstep with U.S. stocks, they're still performing similarly to stocks.

Other alternative assets also have had high correlations to stocks in recent years. Real estate investment trusts (REITs) have an even higher correlation than commodities, moving more in synch with stocks. The performance of those exotic institutional investments such as Multialternative and Long/Short Equity funds—which use leverage as a tool to beat an index—perform even more closely to stocks. The only difference is price. On average, stock funds (even the more expensive actively managed funds) cost less than half of many of those alternative solutions.

Bring it all together and you'll see that adding alternative investments to a portfolio doesn't always produce greater returns or reduce volatility. To illustrate that, we took a portfolio constructed by a fund manager in 2012 that included stock funds, bond funds, and alternative investments (see chart on facing page). We then "invested" $100,000 in the funds, in the proportions indicated in the portfolio: 41 percent was invested in six stock funds, 28 percent in four bond funds, and 31 percent in four alternative funds. We examined the performance since the portfolio was published in June 2012 and compared the returns with the same portfolio without the alternative funds.

Less is still more (at least for now)

When we compared the performance of a portfolio with alternative investments including Absolute Return and Market Neutral funds with a traditional portfolio, the alternative portfolio performed significantly worse.

The result: The alternative fund portfolio grew to $123,900—up 23.9 percent from June 2012 to September 2014. But the portfolio without the alternative funds, composed of 59 percent stocks and 41 percent bonds, appreciated more, growing to $131,900. Moreover, it did so with similar volatility as the portfolio with alternatives.

To be fair to the portfolio, the example doesn't take into account any rebalancing, or perhaps other adjustments a portfolio manager may have made over the 27-month period. Another point is that two years is not an especially long time to decisively conclude that alternatives fall short of their promise.

Still, the performance raises questions. Among them: Should you consider adding alternatives to your portfolio? In the future, interest rates are expected to rise, which will hurt bond returns. In such an environment, alternative funds may have a role. Another reason to consider them: The Standard & Poor's 500 Index is up more than 200 percent since 2009, and some, though not all, investment strategists are concerned that stocks are becoming overvalued, with a price earnings ratio of 16.

No one has a crystal ball and knows what may or may not happen to the market in the future. Though alternatives have made significant contributions to the returns of the investors during difficult times for equities in the past, currently alternative investments appear to be a costly accessory to the traditional portfolio of stocks and bonds. And although alternatives have not lived up to their portfolio-boosting abilities in recent years, if stocks do indeed fall, you may find yourself yearning for a share of, say, gold to buffer the impact on your portfolio.