As investors suffer through this year's unstable market, the wounded are talking about alternative investments. The reason for the category's increasing allure: More investors are seeking vehicles that purport to move in different directions from stocks or bonds.

Alternative investments comprise a nebulous category. Morningstar includes nontraditional asset classes such as commodities, real estate, infrastructure, private equity and venture capital. These assets can improve the risk-adjusted performance of a portfolio because their movements are not correlated with those of traditional securities.

Commodities, for example, have proved their worth as diversifying agents, racking up robust gains during the stock market's drop. We don't think recent gains in commodities are sustainable over the long term. There certainly appears to be froth in certain commodities, with even Congress stepping in to hold hearings on speculation. Nevertheless, commodities will likely continue to offer a low correlation to the stock market—and a hedge against inflation.

Absolute Return

Other assets that we label "alternative" include those used for absolute return strategies. In these strategies, portfolio managers actively hedge market risk, with the goal of achieving returns that are not highly correlated with those of stocks or bonds. These funds attempt to capture a sizable portion of the upside of the stock market, with low volatility. They also claim to provide protection during down markets.

While alternative investment strategies are gaining traction in the advisory community these days, they are hardly a new concept. Institutional investors, such as the endowment funds of Yale and Harvard universities, have dedicated a significant portion of their portfolios to alternative investments for some time, to impressive effect. The Yale University Endowment's annual report for 2007 states that its target allocation to mainstream asset classes (domestic and foreign equity and fixed income) represented 30% of assets, with the remainder devoted to real assets (28%), absolute return funds (23%) and private equity (19%).

This isn't to say that advisors should attempt to duplicate the Yale Endowment's asset mix. Hardly. Most investors don't have access to the absolute return strategies available to giant institutions like Yale, including the very best private equity and hedge funds. Moreover, Yale has tremendous capabilities to manage a portfolio that employs these sophisticated strategies.

Yet examining the ways institutional investors like Yale use alternative investment strategies in their portfolios is a worthwhile exercise that yields useful insights when considering the host of retail-oriented alternative investment vehicles that have been launched in recent years. This proliferation of products means that retail investors are no longer confined to choices that are illiquid, fee-laden or opaque. Indeed, it has become much easier for noninstitutional investors to create endowment-like portfolios using mutual funds.

At Morningstar Investment Services, we use alternative investments to create diversified absolute return strategies and to reduce risk in our asset allocation portfolios. For our dedicated absolute return strategy, we combine funds that provide exposure to nontraditional asset classes with several others that employ absolute return strategies. We typically use the latter group as the core holdings of a portfolio and build around them with funds that offer exposure to nontraditional asset classes.

Compared with strategies for traditional asset classes, we believe that alternative investments require investors to be more tactical in making allocations to asset classes—such as real estate and commodities—because they're subject to wilder price swings. For instance, because of the recent fast and furious run-up in commodity prices, there's now some risk of a short-term price correction. So we currently have a smaller position in commodity funds than we held previously.

Managing Risk

In addition to using alternative investments in absolute return strategies, we use them across various other strategies. Alternatives are a specific asset class in our strategic asset allocation process. The allocation to alternatives varies depending on the given portfolio's specific risk profile and objectives, but the target allocations we use range from the mid-single digits to more than 20%. In general, we have larger allocations to alternative in these strategies that emphasize capital preservation because we employ alternatives as a means of managing risk; their inclusion can reduce the overall level of volatility in a portfolio.

There are many mutual funds that give exposure to nontraditional asset classes, including commodities, real estate, Treasury inflation-protected securities (TIPS) and infrastructure. The following are examples of mutual funds that offer exposure to nontraditional asset classes and absolute return strategies that we currently use in our portfolios:

* Specialty-natural resources and specialty-precious metals funds. Many of these invest in the common stocks of companies that operate in the energy, materials and mining industries. Although returns of many such funds have been phenomenal of late, we prefer to go with a mutual fund that invests in commodity derivatives for pure, diversified exposure to the asset class. PIMCO Commodity Real Return (PCRAX) fits that bill (see Different Breed), as it invests in derivatives that seek to mimic the returns of Dow Jones-AIG Commodity Index. Because the fund invests in derivative securities, a small amount of assets affords exposure to the benchmark. It invests the remainder of its assets in bonds, primarily TIPS, which serve as collateral for futures positions.