When I think about the portfolio construction process it brings to mind a few good books I’ve read over the years. Books like: “Asset Allocation,” by Roger Gibson, “Random Walk,” by Burton Malkiel, and of course there’s Fabozzi’s “Handbook of Fixed Income Securities,” and Ibbotson’s annual edition of “SBBI Yearbook.” But one of my more recent reads, “The Ivy Portfolio,” by Faber and Richardson (Wiley, 2009) was especially interesting as it chronicles the performance of the Harvard and Yale endowment funds’ exceptional period of outpacing the stock market with considerably less risk. It is this latter book which confirmed my already staunch belief in alternative investments, the topic of this week’s blog.

I had been using alternatives for a number of years prior to reading this book but after reading how Harvard and Yale utilized alternatives, I have increased my allocations to this important asset class. It is my belief that as the percentage of stocks in a portfolio rises, alternative investments should also be increased. At the end of this blog, I’ll list the ticker symbols of some of the alternatives I use.

First, I realize there is some disagreement as to what constitutes an investment’s classification as “alternative.” That said, here are some of the investment categories I consider to be alternatives: currency, hedge funds, merger arbitrage, long-short or market neutral, commodities, and real estate. Some are more closely correlated to stock than others–such as real estate–but these are the categories I include.

After reading The Ivy Portfolio, I realized there’s a great difference in what an advisor has available compared to a large endowment. For example, an endowment can invest in the choicest private equity offerings, while the individual advisor probably cannot. Moreover, where Harvard or Yale may buy actual timber land, an advisor may buy an ETF.

Here are a few of the alternative investments I use.

Mutual Funds

o Hedge Fund: Absolute Strategies I (ASFIX)

o Merger Arbitrage: Arbitrage R (ARBFX)

o Long-Short: TFS Market Neutral (TFSMX), Highbridge Statistical Market Neutral (HSKSX)

o Commodities: Prudential Jennison Natural Resources Z (PNRZX)

Exchange Traded Funds

o Currency: PowerShares DB US Dollar Index Bearish (UDN)

o Commodities: iPath S&P GSCI Crude Oil Total Return Inx ETN (OIL), SPDR Gold Shares (GLD)

I use the currency and commodity ETFs in a more tactical fashion. I’d be interested to know how you use alternatives in your practice and which ones you like.

Thanks for reading.