Tuning In To Alternatives

January 02, 2007

[NOTE: In an earlier version of this article, the colors in Figure 5 were reversed. As a result, the figure suggested that adding commodities exposure to a portfolio increased the risk and decreased the return; in fact, the opposite is true. A corrected version appears below.]

Alternative asset classes have become an important part of most institutional portfolios. Even union pension plans—the designated drivers of institutional investors—have begun incorporating alternatives into their strategic asset allocation. Individual investors can reap the same benefits from these asset classes, but until recently, they have had more difficulty in gaining exposure to certain markets.

Rapid expansion of the ETF marketplace has democratized many alternative asset classes, giving individual investors efficient and reasonably priced access to these markets. This article looks at the long-term, strategic implications of an allocation to three alternatives: real estate investment trusts (REITs), commodities and emerging markets.

Constructing A REIT Portfolio
Most institutional investors have come to recognize the benefits of an investment in real estate1, including:

  1. Diversification of overall portfolio risk that results from the low correlation of real estate with other asset classes.
  2. Returns above the risk-free rate. (Ten-year annualized returns are higher than 15 percent.)2
  3. Hedge against inflation through rent increases.
  4. Strong cash flows in the form of rental income.

Prior to the creation of REITs in 1960, direct investment in real estate was the only option for this asset class. But the large capital requirements, specialized skills and significant time commitments made exposure to real estate beyond the reach of most investors—institutional and individual alike. Today, ETFs that hold shares of REITs offer all investors the benefits of low correlation with other assets, diversification within the asset class (geographically and by building type) and low management fees.

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