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Outlook 2012: Key to Alternative Investing Is More Diversification

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One year ago, in a story about novel alternative investment ideas for 2012, we reported on rhodium, rice and Florida timberland as ideas favored by some of the investment cognoscenti at that time. With our journalists’ scorecard in tow, one would have to say that these investment alternatives made for rather dismal investments–though it is important to add the important qualification that one year is far short of true investing, which is inherently long term.

A chart of rhodium prices for the year is a nearly perfect downhill slope; even a steep May spike never managed to reach January’s highs. Altogether, the limited-use industrial metal lost over 40% for the year.

In comparison, rice was nice. Futures contract prices for Asia’s main grain are virtually unchanged from a year ago on the CBOT, hovering in the $14 dollar range.

Bruce Berkowitz of Fairholme FundFlorida timberland, in the form of stock of the St. Joe Co. (JOE), fared nearly as badly as rhodium. You can almost hear the warning “Timber …” shouted as the stock lost nearly 35% for the year–a defeat for Fairholme Fund’s Bruce Berkowitz, whose once high-flying fund (FAIRX) fell by a nearly identical 34% in 2011.

Berkowitz’ loss was a gain for hedge fund manager David Einhorn of Greenlight Capital, who panned the stock at the end of 2010, saying “there’s no ongoing business”–just “a run-down of the assets.”

Investors intrigued with these ideas a year ago might be more interested this year, given their lower prices in addition to the high expectations investment gurus held for them a year ago. And the momentum crowd is surely focused on farmland, perhaps the most discussed alternative investment of 2011 (though not covered in our article).

Jim Rogers and Robert Shiller were among those who sang Nebraska’s praises during the year. And what a year! According to the Kansas City Fed, farmland saw the biggest one-year increase in three decades, rising 25% in the third quarter (compared to 3Q 2010) in the regional Fed’s Midwestern district.

But maybe all this misses the point of what alternative investing should really be about. The asset class is poorly defined, and often encompasses such disparate elements as art, wine (yes, there are actually wine funds and a wine index), postage stamps and antiques, but also include what are now ho-hum commodity investments as well as hedge funds and financial derivatives.

Since the idea of alternative investing is based on widening a portfolio beyond stocks, bonds and real estate in order to reduce risk through diversification, maybe the financial derivatives part of the spectrum–the effort to devise a portfolio that does not easily blow up when stocks and bonds fall together–is more germane to what investors are seeking.

Stephen Hammers, the chief investment officer of Compass EMP Funds, believes he has a solution for that need. In an interview with AdvisorOne, Hammers says both advisors and investors are seeking an alternative to the wild swings the market has been producing of late. “This year has been one of the most volatile years we have seen in a long time, and this volatility is not going away.”

Hammers foresees increased correlation among traditional asset classes in 2012, a trend from which his funds are positioned to gain as a result of their shorting of those assets. Compass’ three funds recently shifted heavily away from long to short positions in the third quarter.

Its commodity assets went from six short positions and 14 long in the second quarter to 17 short and just three long; among its world stock market positions, it went from four short and eight long to short positions in all 12 markets; and its currency holdings reversed from six long and one short (the yen) to six short and one long (again, the yen) during the third quarter.

Hammers says the long-short flexibility of the funds enables them to hedge against the roller coaster of volatility that investors dislike. “Advisors are tired of stocks and bonds,” he says. “They’re looking for help and they know they don’t want to go through the volatility anymore. They say, ‘I’m tired of my clients not making money in the last five years.’”

While investors may welcome the added flexibility, they ought to be prepared for the logical possibility that an investment manager bets the wrong way in his long and short decisions. Still, investors are clearly warming up to the idea of alternative investing.

A recent Morningstar report shows alternatives have netted $11.3 billion in inflows in 2011 (over $20 billion if you count commodities) while U.S. equity funds have seen $54 billion in outflows. And Hammers cites a recent UBS recommendation that its investors allocate 7% to 22% of their investment portfolios to alternatives, up from their clients’ actual 2% allocation.

Volatility has indeed been higher of late, and there is no reason to think another highly correlated crash won’t be in the offing in the new year. For that reason, it does seem sensible for investors to insure their portfolios against blowing up.

And that seems more likely to occur with allocations to commodities and currencies and a long-short strategy than with rice, rhodium and timberland, which may be too narrow to buffer against the headwinds of volatility that many expect in 2012.

AdvisorOne’s Joyce Hanson contributed to this report.

Read AdvisorOne’s complete lineup of Outlook 2012 stories.