The perils of some alts

Having low or negative correlations to stocks isn’t a good enough reason to add an alternative asset to a clients’ portfolio; they must also have positive expected long-run returns.

Here are three alternatives advisors should be wary of.

BEAR MARKET FUNDS

Bear market funds bet that stocks will go down and perform spectacularly if stocks plunge. An example of such a fund is the ProShares Ultra-Short S&P 500 fund (SDS) which borrows to bet against the S&P 500. Its one year annualized return is -33.89% and its five year annualized return is -34.04%, making a $1 million investment now worth around $113,000.

Morningstar shows the overall bear market category having a -26.9% annualized return over the past five years. Five years ago, the “Great Depression Ahead” seemed certain for many.

I often hear advisors say that they use bear market funds to hedge against a market plunge. The problem is they are betting much of the clients’ portfolio that stocks will go up, and the rest on the possibility that stocks will go down. An apt comparison would be betting on both Seattle and Denver to win the Super Bowl, a bet you are sure to lose.

MANAGED FUTURES

Next, managed futures seem like the ticket and were quite hot for a while though returns have turned negative over the past few years. But do you know that, in the aggregate, not a penny has ever been made in the futures market? And that’s before costs, meaning your expected return is negative after costs. Futures were designed to manage risk and it certainly makes sense for an airline to buy jet fuel futures to make a major cost component predictable.

MARKET NEUTRAL FUNDS

Finally, market neutral funds sound wonderful as they aren’t betting on any market direction. They become less wonderful when considering that a true market neutral fund has a zero beta or, in other words, its expected return before costs is the risk-free rate which is pretty close to zero. The after-cost expected return is also zero.

These three alternative asset classes are appealing in theory until you stop and think about them. I wouldn’t want to be explaining to a client why I recommended any of these three asset classes and suggest you avoid them, too.

Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes for CBS MoneyWatch.com and has taught investing at three universities.