When the temperature dips and the leaves change color, Jerry Miccolis knows it's time for his annual review of his clients' asset allocation models. These portfolios already reach well beyond plain-vanilla stocks and bonds to include alternative asset classes ranging from international real estate and commodity funds to hedge funds, timberland and managed futures. Despite this wide array, Miccolis isn't about to call a halt to his quest for new types of investments.

"We want asset classes that we believe will add diversity to the overall portfolio," says Miccolis, senior financial advisor at Brinton Eaton Wealth Advisors in Madison, N.J. He and his colleagues are now considering investments in water, agricultural land and infrastructure. "We don't agonize over how we get exposure to these sectors, but we want a presence in any market that is going to have a different pattern of risk and return from traditional asset classes," Miccolis explains. "Even before this fall's market turmoil, we had concerns that markets that used to give us diversification weren't doing the job as well as before, as more and more speculators and legitimate investors moved into areas like commodities."

Opposites Attract

Miccolis is searching for the perfect negative correlation: an asset class whose price moves in the opposite direction to that of mainstream investments like stocks and bonds. Investors need this kind of diversification. As scholars have demonstrated, asset classes with low correlation levels help generate better risk-adjusted returns. At times of crisis, alternative asset classes that deliver a low correlation to stocks and bonds can be the key to achieving outperformance—or even to making the difference between making money and posting a loss. The credit crunch and the stock market meltdown it triggered have wiped billions of dollars of value from stock and bond holdings, and pleas to advisors and brokers to find a safe haven for remaining assets have become increasingly frequent and fervent.

But there is a problem facing advisors like Miccolis who are hunting for uncorrelated asset classes. "When the markets really tumble, they take no prisoners. Everyone is hit, and correlation levels just zoom upward," explains Lewis Altfest, associate professor of finance at Pace University's Lubin School of Business and president of advisory firm L. J. Altfest & Co. in New York City. The reason is straightforward, notes Robert Whitelaw, finance department co-chair at New York University's Stern School of Business. "Global news or events with global impact make markets react in similar giant leaps and bounds," he says. "In normal conditions, smaller, local news events drive markets."

Yet when markets go haywire, so do correlation levels. A big influx of liquidity in either direction can cause correlations to rise, but the most significant cause of a surge in the degree of correlation between disparate markets is the kind of global financial crisis that investors and their advisors have experienced this year. In a crisis, all markets react similarly: Investors flee anything they perceive as remotely risky, from hedge funds to blue-chip stock portfolios.

Hedge funds—typically, portfolios made up of stocks and bonds, often constructed using leverage—have been hammered. As global economies slumped in response to the credit crunch, so did commodity prices. By late October, crude oil prices had fallen to about half of their peak. "For a savvy advisor, it's not just the absolute negative return that is a concern, but the fact that these asset classes are now moving in tandem to a greater degree," Whitelaw says.

Yet experts say now's the time for advisors to maintain or even expand their allocations to alternative asset classes, however risky or painful it may feel to do so. "You may have to cast a broader net in searching out the right asset classes, but the only free lunch in finance is through diversification," Whitelaw argues. "Restrict yourself to stocks and bonds, and you've eliminated entire sets of return and diversification benefits." Advisors are accustomed to urging clients to remain calm during market meltdowns and to focus on the long-term prospects for both absolute and relative returns while seeking undervalued sectors. Similarly, they themselves must look beyond temporary market conditions to construct the best possible portfolios-ones that include some kind of exposure to alternative assets.

Defining Alternatives 

But adding alternatives is complicated by the fact that many advisors don't agree on what an alternative asset class is, much less which flavor of alternative portfolio is the best hedge against continuing turmoil in stocks and bonds. "By definition, an alternative asset class is a portfolio that does anything other than hold long-only positions in equities or fixed-income securities," says Shana Orczyk, research analyst at Peak Financial Management in Waltham, Mass. That classification includes such traditional alternative asset classes as commodities as well as hedge funds that use traditional asset classes in innovative strategies to produce an uncorrelated portfolio. "If you have a market-neutral fund, the manager could be using stocks but has built a portfolio of long and short equities," Orczyk says. Her definition opens the door to an array of investment possibilities, including venture capital and private equity.