Alternative Investments

Alternative asset classes act as defensive hedges in a portfolio. Investments such as gold, real estate and hedge funds are not correlated to market performance and therefore can provide useful diversification, particularly for large portfolios, by decreasing the risks of traditional investments, such as stocks and bonds.

However, alternative investing requires high risk tolerance as these assets can be very volatile. For this reason, some alternative investments are only appropriate for high-net-worth investors. At the very least, they should only represent a small portion of a portfolio.

Why invest in gold?

In times of geopolitical turmoil and economic uncertainty, many investors gravitate toward precious metals, such as gold, because hard assets look more attractive when stocks and bonds are floundering. Gold is also a hedge against inflation-when inflation rises, so do gold prices. Therefore, the value of your investment does not erode in an inflationary environment as it might with other types of investments.

While gold can be an important hedge, investors should remember that gold prices are highly erratic, and gold investments can experience years of underperformance. Most experts recommend no more than a 5 to 10 percent allocation to gold.

How can I invest in gold?

You can invest in gold in the following ways:

• Bullion coins and bars: Coins and bars can be purchased through gold dealers or through brokers. American Eagle coins are the most popular bullion coins. Coins intended for investment are not to be confused with what are called numismatic coins, which are collectables.
• Gold stocks: Investing in shares of companies that mine and produce gold is less risky than owning the hard asset. While any gold company's prospects will be closely tied to the price of gold, you are also investing in the firm's financial and operating strength.
• Gold mutual funds: There are sector funds that invest exclusively in the stocks of gold companies. Buying gold funds is probably the safest way to invest in gold because you are spreading your risk among many different companies.

What are real estate investment trusts (REITs)?

While real estate investments depend on the general health of the economy, they are not correlated to the stock and bond markets and can provide a hedge against those associated risks.

REITs are companies that own and operate various types of properties-from apartment buildings to shopping malls to office parks-and generate revenue from leases. By law, REITs are required to return almost all profits to shareholders as dividends. As a result, REITs typically pay above-average yields. REITs are especially attractive to investors seeking regular income streams.

Like other alternative asset classes, real estate is a volatile sector. Property markets in different parts of the country can vary widely, and different types of properties may do well when others are doing poorly. When considering REITs, evaluate what exposure they have to these cyclical elements and look at their overall financial strength.

By buying a sector fund that invests exclusively in REITs and real estate-related stocks, you can reduce the concentration risks involved in owning one or only a few REITs.

What are "hedge funds"?

Like mutual funds, hedge funds are pools of assets collected from investors and used to purchase various types of publicly traded securities. But, while mutual funds are strictly regulated, hedge funds have much more leeway in how they run their portfolios.

By law, mutual funds are restricted in terms of how much leverage they can use and how much they can invest in certain types of securities. Mutual funds must follow disclosure requirements regarding fees and performance. Mutual funds are intended for the average investor and have very small minimum investment requirements. Mutual funds are priced every day and are required to let shareholders redeem their shares at any time.

Hedge funds, on the other hand, are exempt from regulation by the SEC, other than antifraud laws. Hedge funds are allowed to use unlimited amounts of leverage, take short positions and invest in whatever type of financial instrument they want, such as derivatives. All of these strategies involve a great deal of risk but can also dramatically boost returns. Hedge funds usually only allow investors to redeem shares on a quarterly or annual basis.

Hedge funds are targeted toward high-net-worth individuals, who are supposed to be more sophisticated investors capable of taking on greater risk. According to SEC regulations, only investors with a certain amount of assets are qualified to invest in most hedge funds. Because hedge funds are not allowed to advertise or offer broad solicitations to the public, investors can usually only get access to hedge funds through referrals from financial advisors or other investors.