Jitters about the stock market and the bond market have many investors wondering whether it’s time to include some other types of investments in their portfolios.
Top financial adviser Charles Zhang says that some of these so-called “alternative investments” will do well because they are among the few bargains left in the investment world…and because inflation will start to rise, hurting the stock and bond markets. Bottom Line/Personal spoke with Zhang about how our readers could use alternative investments and which ones to choose…
If you’re willing to move just a little outside the comfort zone of traditional holdings, then adding certain alternative investments is likely to stabilize your portfolio and improve overall performance. It’s true that alternative investments carry their own risks. They can be volatile and hard to understand, and with inflation still low, they generally have been weak in recent years. But alternative investments have proved to be valuable diversifiers when mixed with other investments.
I am convinced that this kind of diversification will be vital over the next few years, especially for older and retired investors.
Reason: It’s likely we will face the highest inflation in decades, a period of rising prices that will erode the buying power of your money. That’s because powerful, global economic forces are aligning to start pushing up inflation. These forces include the end of cheap labor costs from emerging markets that have kept the price of consumer goods low for years…and the willingness among developed nations to pay off their massive debts by, in effect, printing new money rather than curbing spending.
Rising inflation typically is followed by higher interest rates, which hurt the value of most bonds that you already own and eventually stocks as well. In contrast, certain types of alternative investments actually thrive on inflation.
In the next few years, I expect the inflation rate will rise to 5% or higher. That is why I am investing in the types of alternatives described below. They all have very little correlation with, or move in the opposite direction of, the broad stock and bond markets, and each one provides different kinds of protection and opportunities.
Remember, the time to buy inflation insurance is when it’s cheap, and in my view, these alternatives now are selling at bargain prices.
The particular investments that you choose are as important as the category. I generally use funds, but I avoid funds that use highly complex strategies, charge high fees and/or make it difficult to gauge the risk you’re taking. These include “leveraged” funds that use borrowed money to invest…funds that short (bet against) specific investments…and hedge funds, which often charge high fees and lock up investors’ money for extended periods of time.
Instead, I prefer low-cost exchange-traded funds (ETFs) that I can buy and sell as easily as stocks and that allow me to see exactly what I am investing in. For a typical investor, it might make sense to buy equal amounts of each of the following three funds plus Treasury Inflation-Protected Securities (TIPS), as described in the box below, so that they constitute a total of 20% of your overall investment portfolio (5% in each category). My favorites now…
Vanguard REIT Index ETF (VNQ). Over the past 15 years, shares of real estate funds have outperformed US stocks, returning 10.7% annualized versus 4.5% for the Standard & Poor’s 500 stock index. Their high dividends also make them attractive as income providers.
Real estate investment trusts (REITs) can be especially appealing in inflationary periods because rents and real estate values tend to climb with rising prices. This Vanguard ETF tracks the MSCI US REIT Index, which includes office, mall, health-care, apartment, industrial and hotel REITs. Recent yield: 2.9%. Annual expense ratio: 0.1%.
PowerShares DB Commodity Index Tracking ETF (DBC). Commodities can be volatile, and their poor short-term performance has left them extremely undervalued. Overall, they lost 7.6% last year and have returned an average of just 5.8% annually over the past five years. But commodities are likely to be one of the best-performing investments in periods of fast-rising inflation because the prices of raw materials used to make consumer goods tend to soar. This fund uses futures contracts to track the prices of 14 different commodities, mostly oil and gas, agriculture and industrial metals. Annual expense ratio: 0.85%.
SPDR Gold Shares ETF (GLD). After peaking above $1,900 per ounce, gold lost its appeal for investors and fell 28% in 2013. Gold’s longer-term performance is equally dismal. Since 1980, it has gained an average of 3.4% annually. But in a limited strategic role as portfolio insurance, owning gold still makes sense. Although gold prices don’t increase directly with inflation, they do tend to move in the opposite direction of the US dollar’s value on global currency markets—and if inflation in the US spikes, the value of the dollar typically depreciates against other major currencies. Annual expense ratio: 0.4%.
Treasury Inflation-Protected Securities (TIPS) are bonds, but they are structured specifically to provide protection in the event of rising inflation. TIPS, issued by the US Treasury, pay interest twice annually based on a fixed rate. Unlike ordinary Treasuries, the principal value of TIPS adjusts up and down based on the Consumer Price Index (CPI). The payout you receive is based on the adjusted principal.
Example: You invest $10,000 at the beginning of the year in a new TIPS 10-year note with a 3% rate. If inflation is 1% during the first six months of that year, then by midyear the inflation- adjusted principal amount of the security will be $10,100 and you will receive the first semiannual interest payment of $151.50 ($10,100 times 3% divided by two).
While you are guaranteed to receive the return of your principal upon maturity, TIPS do carry some risk. For example, deflation (falling prices) could cause the value of your TIPS holdings to drop before maturity. So could a sharp drop in what investors think future inflation will be, which is what happened in 2013 when the Barclays Capital US TIPS index lost 8.6%. You can purchase TIPS directly at TreasuryDirect.gov.
