The stock market crash of 2008-09 did not simply wipe out $6 trillion in wealth in the United States. It also shattered many investors’ confidence in diversification. That’s completely understandable. The conventional wisdom, that a portfolio diversified among stocks of large and small companies, growth and value strategies, and domestic and foreign firms would be well-positioned to navigate a volatile market, proved disastrously incorrect. A portfolio evenly distributed across those categories would have lost about 57% over the market’s entire decline, from 2007 to 2009, which is comparable to the actual 55% drop in the Standard & Poor’s 500-stock index.

The failure of such wisdom, however, is not in diversification itself (diversification, when done properly, works), but in the outdated tools that conventional wisdom suggests you use to create a well-rounded portfolio. Diversification improves returns by spreading money among assets that do not swing up or down in tandem with one another – in other words, assets with low correlations to one another.

Even as recently as the early 2000s, dividing your money among companies of various sizes and sectors provided tangible benefits. During the 2000-02 bear market, for example, the S&P 500 lost 47.4%, but shares of small, undervalued companies gained 1.6%, and stocks of real estate investment trusts gained 36.6%.

This was not the case during the recent bear market. Small, undervalued businesses lost 59.6% of their value. REITs lost 68.5%. Even the typical non-government bond fund lost 3.2% (while the typical fund focusing on US government securities gained 9.2%). In other words, what was considered “well-diversified” less than ten years ago is no longer sufficient.

Paying attention to correlations is one way to find investments that should fare better in another downturn. If the concept sounds abstract, consider the concrete advantages of holding investments that do not tend to move in lockstep. A simple thought experiment demonstrates the benefits: Assume you had a portfolio consisting of two assets: Stock A and Bond B. Assume that Stock A and Bond B have a perfect negative correlation and are both equally volatile. Consider that Stock A will likely return 10% per year over the long term, while Bond B will likely earn 6%. (Albeit with plenty of volatility along the way). Because of their inverse relationship, when Stock A returns more than 10%, Bond B returns less than 6%. Because of this relationship, the growth of a portfolio evenly split between the two assets would look like a straight, upward line – your return would be a consistent 8%. “You can build a portfolio that is more durable and has a more stable path” by incorporating investments that do not move in lockstep, according to Carter Furr, manager of alternative-investment strategies at Signature, a Norfolk, Va.-based investment adviser. Furthermore, with regular rebalancing – which forces you to load up on Stock A when it underperforms and Bond B when it outperforms – your portfolio’s returns could exceed 8%.

Investors must now look further afield than ever before to find investments that march to the beat of their own drummer. Some of these asset classes may be unfamiliar to you, but keep in mind that they are not necessarily riskier than traditional stock investments. Some are downright gentle. We outline five options for your consideration on the following pages. Depending on your risk tolerance, a 5% to 35% allocation to these alternative assets may be appropriate.


WHAT ARE THEY: Historically, investments in oil, precious metals, crops, and other commodities have been good inflation hedges. Some commodities, such as gold, can be purchased directly. Others, such as oil and gas, are more practical to invest in commodity-producing companies’ stocks or to track commodity prices with derivatives.

OUR FAVORITES INCLUDE: The Pimco CommodityRealReturn Strategy (PCRDX) is the best option for investing in a diverse portfolio of commodities. Manager Mihir Worah employs derivatives to replicate the Dow Jones UBS Commodities index’s returns. But he can also place small side bets to try to outperform it. Worah invests the remaining cash in a bond portfolio because the fund’s derivative positions only account for a small portion of its total assets. Since Worah took over as manager in early 2008, the fund has lost 2.2% annualized, but it has outperformed the index by four percentage points per year on average (the fund lost 43.6% in 2008). Gold investors should consider purchasing the iShares Gold Trust (IAU), an exchange-traded fund that tracks the metal’s price. Gold is an excellent hedge against a falling dollar, which could lead to inflation. Over the last five years, the fund has returned 24.6% annualized (for more on gold, see Gold: Long-Term Hedge or Bubble About to Burst?).

BEST FOR: Investors who are concerned about inflation but can tolerate wild price swings.

Long-term bond funds

WHAT ARE THEY: This type of fund owns bonds in the traditional sense, but it also sells certain bonds short. It shorts bonds in the same way that it shorts stocks: it borrows a bond from a broker and sells it into the market, hoping for the bond’s price to fall so that the fund can repurchase it at a lower price.

OUR FAVORITES INCLUDE: The best option for a tax-deferred account is Driehaus Active Income (LCMAX). Its managers take long and short positions in corporate and government bonds, with the goal of keeping the portfolio’s duration (a measure of interest-rate sensitivity) at zero. Because it has a zero duration, unlike other bond funds, it should not suffer if interest rates begin to rise. Over the last three years, it has returned 8.5% annualized while experiencing less volatility than the average bond fund. Forward Long/Short Credit Analysis (FLSRX) is a better option for a taxable account. Managers of the fund can take long and short positions in municipal bonds, corporate bonds, and Treasuries, but they aim to generate more than half of the fund’s income from tax-free munis. Since its inception in May 2008, the fund has generated an annualized total return of 13%. It will, however, most likely be as volatile as a typical high-yield bond fund. Both funds have shown no correlation with the overall bond market.

BEST SELECTION FOR: Bond investors who are concerned about rising interest rates.

Long-short equity funds

WHAT ARE THEY: These funds, in addition to owning stocks, can sell short individual stocks or stock indexes in order to profit when stock prices fall. A long-short stock fund manager makes money primarily in two ways: by adjusting the ratio of short positions relative to a fund’s “long” holdings (the more stock sold short, the less the fund will participate in market gains and the better it will do in falling markets), and by carefully selecting the specific stocks he purchases or shorts.

OUR CHOICE: Hussman Strategic Growth (HSGFX) founder John Hussman approaches money management with caution. He typically keeps his fund tightly insulated from the market’s whims by selling short the S&P 500 and other indexes. This is a boon in bear markets but a curse in bull markets; the fund lost only 6.5% during the 2007-09 bear market but has gained only 4.9% since. Hussman says he is wary of stocks because he believes they are overpriced and have been for some time. However, if stocks become too cheap for Hussman, he can increase Strategic Growth’s stock-market exposure by closing the fund’s short positions. Since its inception in 2000, the fund has returned 7.4% annually, compared to 0.1% for the S&P 500.

BEST FOR: Investors who are wary of the market but don’t want to abandon stocks completely.

Managed futures

WHAT ARE THEY: Most managed-futures investors use momentum strategies. In other words, they are betting that investments that have been performing well will continue to do so. Because the managers invest in futures, which are derivatives that allow you to bet on the future price of an item, they can bet on a variety of instruments and asset classes, such as stocks, interest rates, commodity prices, and currencies. And, because traders can bet on whether prices will rise or fall, they can profit in both up and down markets. Managed-futures investments have yielded an annualized return of 11.6% over the last 30 years.

OUR FAVORITES INCLUDE: Rydex|SGI Managed Futures Strategy H (RYMFX) tracks a computer-driven index designed to mimic a common managed-futures strategy. Since its inception in early 2007, the fund has returned 1.6% annually, compared to the S&P 500’s 1.2% annualized loss over the same period. The results include a whopping 18% gain during the 2007-09 bear market. Consider Altegris Managed Futures if you work with an adviser who can provide you with access to load funds with no commissions (MFTAX). This new fund invests with a group of top futures managers that the average investor may not have access to.

BEST FOR: Investors with a high-risk tolerance looking for high returns.

Merger arbitrage

WHAT IS IT? A company typically pays a premium above the target’s share price when acquiring another firm. When the deal is announced, the target’s stock usually rises, but not all the way to the purchase price. The shortfall reflects the possibility that the deal will fail or be renegotiated. Merger arbitrageurs purchase a target’s shares after a deal is announced and hold them until the merger is completed, hoping to profit from the last few dollars (or cents) of appreciation between the post-announcement price and the deal price. If an acquiring company pays for the target with its own stock, merger arbitrageurs may sell short the acquirer’s stock to protect themselves against a decline in the buyer’s stock price. Merger arbitrage has traditionally been a low-risk strategy.

OUR CHOICE: Merger Fund (MERFX) co-managers Roy Behren and Michael Shannon are veterans of the game. According to them, the biggest risk in such a strategy is that a deal will fail, so their challenge is to invest only in deals that will succeed. In general, approximately 90% of all announced deals are completed, compared to approximately 98% of the deals in which they choose to invest. At any given time, they have 45 to 65 pending deals. Over the last 15 years, the fund has returned 6.4% on an annualized basis, with one-fourth of the volatility of stocks. In 2008, it lost only 2.3%.

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