When considering commodities, don't neglect their diversification benefits, which historical research has amply demonstrated, says Hilary Till, principal of a proprietary trading firm in the Chicago area and author of Intelligent Commodity Investing (Risk Books, 2007). An investor who isn't an expert in a given commodity but wants the broad-based portfolio effects has to turn to diversified commodity investments, says Till. An index, which takes advantage of statistical properties of commodities, or a natural resources fund of funds, will allow that client to invest in a theme rather than something relatively esoteric, such as cocoa, which would require particular expertise. But even if one is invested in hedge funds, the investment should be diversified across idiosyncratic managers, to limit damage from a big loss.
Another alternative that provides diversification is private equity. Rick Rickertsen, managing partner at Pine Creek Partners in Washington, D.C., says that the primary appeal of private equity is stellar returns over the past five years: 18% versus 8% to 9% for equity investments and 4% to 5% for bonds. These investments "juice" the portfolio, he says. But private equity also provides important diversification.
Rickertsen also points out that private equity is no longer exotic; last year, it enjoyed record inflows. He acknowledges that these investments put special demands on investors in the form of a long period of illiquidity and that they involve risk--which might include rising interest rates, for instance--but says that avoiding this alternative after five years of strong returns could very well have meant putting one's clients on the sidelines during the current run-up.