Clients seem to clamor for alternative assets these days, and adding them to investment portfolios has gained increased acceptance, or at least increased consideration. To be sure, the definition of alternative assets differs from person to person. In this study, alternative assets are limited to commodities, energy, precious metals and real estate.

This study examines the historical impact of adding energy, precious metals or real estate and a combination of the three to a portfolio in lieu of a full-fledged commodities fund. Why make these comparisons? One reason is that actionable commodities-based mutual funds and exchange-traded funds are relatively new products, even though annual performance data for the S&P GSCI Commodity Index is available dating back to 1970. By comparison, actionable mutual funds that specialize in real estate (REITs), precious metals and energy stocks have long histories.

In addition, mutual funds that attempt to track commodities indexes, such as the S&P GSCI or the Dow Jones AGI Commodity Index, use structured notes and derivatives, which create a far more complicated fund structure. Therefore the study examined whether or not energy, real estate or precious metals are reasonable surrogates for commodities. (All performance data used in this study was obtained from Morningstar Principia.)

The primary objective of this study was to identify the effect of adding these three alternative assets to a core equity/bond portfolio in the preretirement accumulation mode and during the retirement withdrawal phase. I compared these three asset classes—singly and combined—with the impact of adding a commodities index to a core portfolio.

As the term would suggest, alternative assets are garnishments to a portfolio, rather than core assets. The core assets in this study included large and small U.S. equity, international growth and value equity, U.S. bonds and U.S. cash. I used the performance of Vanguard mutual funds to represent the core assets: the 500 Index, the Small Cap Index, International Growth, International Value, Total Bond Index and Money Market Prime. All these funds had performance histories going back to Jan. 1, 1987. The time frame of the study was the 20-year period ending Dec. 31, 2006.

The performance of commodities is represented by the S&P GSCI Commodity Index (known as the Goldman Sachs Commodity Index prior to Feb. 6, 2007). As of late May 2007, the S&P GSCI was composed of 70.1% energy, 11.35% industrial metals, 2.3% precious metals, 11.39% agriculture products and 4.87% livestock.

As energy comprises the largest single component of the S&P GSCI, it was logical to assume that an energy-based mutual fund might serve as an appropriate surrogate for the index. The performance of energy is represented by the Vanguard Energy Fund.

Why consider real estate or precious metals as an alternative to commodities? There's a good case for including real estate as an alternative because of impressive historical returns and low correlation. The case for precious metals (PM) is modest at best. But since industrial and precious metals are included in the S&P GSCI—albeit in a relatively small percentage—PM becomes a candidate as a commodity surrogate. Plus, PM has a long history, though perhaps not a wide one of being used as an alternative asset. Precious metals are represented in the study by the Vanguard Metals and Mining Fund, and real estate, by the Fidelity Real Estate Fund. These particular funds were selected because of their long performance histories.

Looking at Alternatives

The study tracked three different core portfolios: conservative, moderate and aggressive. The conservative portfolio had a 40% equity/60% fixed income allocation, the moderate portfolio had a 60%/40% mix and the aggressive portfolio had a 90%/10% allocation. Note that the conservative portfolio doesn't make much sense in the accumulation mode because it's so fixed-income heavy. Likewise, no financial planner would advocate the equity-heavy aggressive portfolio during the drawdown phase in retirement.

When alternatives were added (either as commodities, energy, real estate, precious metals or a mixture of the last three) the equity allocations in each portfolio were reduced to create the needed space. The alternative asset allocation in the conservative portfolio was 10%, the modest was 20% and the aggressive was 30%. (See "The Portfolio Lineup," below.) The blended alternative mix was 50% energy, 30% real estate and 20% precious metals.

I looked first at the accumulation portfolios. (See "Accumulation Phase Portfolios," below.) In the aggressive portfolio, adding an alternative asset of any kind produced a higher return than the core portfolio alone. Energy had the greatest impact over this particular 20-year period ($104,786 versus $78,127). But Adding commodities improved the worst one-month percentage loss more than any of the other alternative assets, from -21.3 to -13.6%). Adding a composite mix of energy, real estate and precious metals to the core portfolio reduced the worst one-year calendar loss to -8.8% compared to -16.6% in the core portfolio alone.