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Evaluating alts: Essential criteria

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The popularity of alternative investments continues to increase.

The sales pitch for alternatives is the low or negative correlations to the stock market. The argument is that portfolios with a healthy dose of alternatives will stand up to the next market meltdown much better than the traditional asset classes of stocks, bonds and cash.

Alternative investments such as bear market and managed futures have negative correlations, and market neutral funds have a very low correlation. Having a low or negative correlation to traditional assets is one important essential for a good alternative investment.

However, many advisors forget the second essential criterion for a good alternative investment: a positive expected return. It so happens that, according to Morningstar, all three of the aforementioned categories have five year negative returns. In fact, most of the alternative investment classes have low or negative returns, according to Morningstar.

Are alternatives just having five bad years? Will they zig (go up) the next time stocks zag (plunge)? Perhaps, yet the question remains whether they will have positive long-term returns. Though they are plagued with very high costs, that’s only part of the problem. Certainly, bear market funds don’t have long-run positive returns if we expect capitalism to work and stocks to increase over the long-run.

Other categories, like market neutral or managed futures, are essentially zero sum games. This doesn't mean there aren't specific funds within each category that have had handsome returns. Even in zero-sum game categories, some funds must be winners and can cover their costs.

But money keeps flowing into alternative investments even with low or negative returns. Before you invest your clients’ funds in an alternative investment, ask yourself how the category is performing. If you are investing in a fund showing great results in a category of low or negative returns, you may be doing classic performance chasing.

I tell clients they could take half of their portfolio to Las Vegas and gamble it. The outcome will have no correlation with the stock market, but that doesn’t make it a smart thing to do.

Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes for CBS MoneyWatch.com and has taught investing at three universities.

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