Recent studies indicate that investors are turning increasingly to commodities, hedge funds, private equity, and other alternative investments to bolster returns and diversify their holdings.

Volatile markets are sending more investors to alternatives. What’s right for you?

With global equity markets on a roller coaster ride — one that never seems to make any headway — many investors are seeking alternatives. According to a recent study by McKinsey & Company, volatile markets are driving an increasing number of investors to commodities, hedge funds, private equity, real estate and other “nontraditional” investments.1

The study indicated that 100% of U.S. investors and 70% of European investors expect alternative investments to outperform traditional asset classes over the next year, and that allocations to alternative investments are projected to increase to 28% of total portfolio assets by the end of 2013.

Another recent survey shows a similar trend among ultra-high-net-worth investors.2 In the survey, 45% of respondents increased their allocation to commodities, 31% to real estate, and 22% to private equity over the past year. The survey also reported the continued popularity of direct investment in private companies.

The two studies underscore the frustrations investors face in today’s volatile equity environment, in which equity performance has been spotty at best. For the one, five, andten years ended December 31, 2011, large-cap equities, a traditional core holding of many portfolios, had total returns of only 2.12%, -0.25%, and 2.92%, respectively.3

Alternative investments tend to have low correlations with stocks and bonds, making them effective portfolio diversifiers. They can also serve as a hedge against inflation. However, alternative investments also come with risks. Assets such as commodities are often more volatile than stocks. Commodity-linked investments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates, or factors affecting a particular industry or commodity. What’s more, hedge funds typically entail steep fees — as well as high risk. Hedge funds are also highly illiquid, may involve complex tax structures, and are not subject to the same regulatory requirements as publicly traded stocks.

Average investors seeking to diversify their portfolios with alternative investments might do better by investing in pooled funds, such as mutual funds that specialize in a particular alternative asset class or exchange-traded funds that track an alternative asset index. They should also be cautious when investing in alternatives, limiting their exposure to any one asset and seeking the help of a professional when choosing among alternatives.

Source/Disclaimer:

1Source: Financial Planning, “Wealth Managers Turn Attention to Alternatives,” June 27, 2012.

2Source: Institute for Private Investors, annual Family Performance Tracking survey, June 2012.

3Source: S&P Capital IQ. Large-cap stocks are represented by the S&P 500. Past performance is no guarantee of future results.

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