Diversification Among Asset Classes

There has been a great deal of press in recent years given to portfolio diversification, in particular to the use of hedge funds as a means of alternative investment strategy. Many times these funds are referred to as vehicles to use for diversification, because they are not linked to traditional investments, such as stocks and bonds. However, on a closer inspection, it becomes evident hedge funds, while using sophisticated tools such as derivatives, controlling purchases in companies, merger arbitrage and venture capital, are still very much connected to traditional investments, and also remain illiquid, expensive and prone to risk.

Are these investments suitable for your portfolio? The answer depends on your appetite for risk, tolerance for illiquidity and overall investment goals. In the past, these funds were marketed to very high net worth individuals, but recently, this unregulated asset class has been marketed to a larger group of investors, in order to increase market performance during times of low returns. Some fee-based Financial Advisors have been recommending them, to increase returns in portfolios, where the advisory fee is deducted from quarterly returns, and paid directly by the client. Many hedge funds have had lackluster performance recently, and this can lead managers to increase the risk, in order to increase the return for the year. Accurate data has only been collected on hedge funds for about 10 years. This doesn’t give much information on which to ” base an analysis, so you need to exercise caution in interpreting such results”, according to Vikas Agarwal, of the J. Mack Robinson College of Business at Georgia State University.

After the technology bubble burst in 2000, there was a rotation out of tech into real estate, energy, natural resources, bonds and emerging markets. Long term holders of real estate and these other asset classes saw huge gains, and mutual funds in these asset classes were the market leaders since the tech bust. Last year, investors began to move money out of real estate as the sector cooled rapidly. In my opinion, the idea is not to switch asset classes and try to time these these rotations, but rather to attempt to build a portfolio, which holds positions in all of these asset classes. This requires a great deal of discipline, because it means holding and purchasing positions, which may be out of favor, at the same time you are building positions in sectors, which are in favor. This is why I recommend adding to your portfolio through dollar cost averaging, and monitoring performance on a calendar year basis. When you look at your statement, check a newspaper, or review performance on the web, you get a snapshot of performance on that date. You will get the year to date return, which is valuable, but the 3 and 5 year returns are as of the date you are looking. While this information is definitely useful, be sure to check your year end data to analyze your annual performance. This should keep you from making knee jerk decisions based on short term new events.