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.

In the moderate 60/40 portfolio, adding alternatives increased returns and reduced account value losses when measured monthly or annually—with the exception of precious metals. While PM did generate a higher return than the core portfolio alone, the worst monthly loss was also higher.

Retirement portfolios are more fragile accounts since they are sustaining periodic withdrawals. (See "Retirement Drawdown Portfolios," below). The accounts were simulated by depositing $10,000 and then withdrawing $75 each month over the 20-year analysis period.

The conservative 40/60 core portfolio without alternative assets ended the 20-year period with a slight loss of principal and had a worst-case one-month account value loss of -8.6%. Adding a 10% allocation to commodities modestly improved the ending account value, but significantly improved the worst one-month loss and the average monthly loss. Adding energy to the portfolio had the greatest impact on performance, but did not materially improve the downside resistance.

The same patterns were observed in the moderate 60/40 drawdown portfolio, which had a 20% allocation to alternative assets. Adding commodities led to the lowest account value losses, while adding energy had the greatest impact on performance.

Adding commodities to a portfolio exerts a noticeable impact—mostly in the improvement of worst one-month losses in both accumulation and drawdown portfolios. But over one-year periods, the non-commodity alternative assets provided better loss protection in accumulation portfolios. In drawdown portfolios, adding commodities provided more downside protection than the other three alternative assets. The reason is low correlation between commodities and the core portfolio assets.

Considering Correlation

The average 12-month rolling correlation between the monthly returns of commodities and the aggregate monthly returns of the moderate core portfolio was 0.05 over the 20-year period. By comparison, the correlation of the moderate core portfolio to energy was 0.61, to real estate, 0.51, to precious metals, 0.33, and to the alternative asset blend, 0.67. Therefore commodities really did the most zigging when the core portfolio assets were zagging. And while commodities may not produce the highest dollar gain compared with the other alternative assets, the low correlation of commodities tends to provide attractive downside protection.

The case for adding commodities is strongest in the retirement portfolio, since minimizing losses is a primary goal when clients are drawing down assets, and commodities produced the best results in that category (as do most low-correlation assets). The other alternative assets, however, were stronger candidates for accumulation portfolios.

Energy and/or real estate appear to be viable alternatives to commodities. Both provided return enhancement in excess of commodities in the accumulation portfolios as well as loss protection during the drawdown phase. Admittedly, the loss protection was inferior to that provided by commodities. But given the logistical challenges of creating and delivering commodity-based mutual funds and ETFs, energy and/or real estate are reasonably attractive "alternatives."

Craig L. Israelsen, PhD, teaches family finance at Brigham Young University. Email him at craig_israelsen@byu.edu.

(c) 2007 Financial Planning and SourceMedia, Inc. All Rights Reserved.

http://www.Financial-Planning.com http://www.sourcemedia.com