WHAT a difference a few years can make. It was not so long ago when alternative asset classes - such as hedge funds, real estate investment trusts, or Reits, and commodity funds - were the purview of private banks and their high net worth clients. In recent years, however, easier access and a better understanding of these non-traditional investments have led to a noticeable increase in retail investors' interest in alternative investing.

News of the spectacular growth and potential of these markets has probably fuelled retail interest. Gold, for example, has gained almost 30 per cent over the past year. However, while offering growth opportunities, such investments can be volatile, especially in the short term. Case in point: gold is currently 18 per cent off its May high of US$730 an ounce.

Rather than focusing on the headlines, investors should look at the other (less obvious) side of alternative investing: diversification. Very simply, economies tend to go through a boom-bust cycle every eight years or so. As different asset classes outperform at different stages of the cycle, investors with an optimally diversified portfolio attuned to their risk profiles could benefit from opportunities no matter how the economic cycle is unfolding.

Alternative asset classes can also be more resilient to factors that could cause equity or bond markets to dip, hence helping to spread risk exposures over the long term. They can help to absorb unexpected shocks in investment portfolios as they are usually not highly correlated to equities and bonds, and may help to prevent existing portfolio gains from being eroded.

Therefore, alternative investments have, on many occasions, fared better than equities in bear markets (see chart). This is because hedge funds are able to employ a range of non-traditional strategies to help limit losses in a bear market. Reits, on the other hand, will continue to pay regular income even when your other investments are not performing.

Note, however, that the diversification benefits of alternative asset classes tend to play out better in the longer term. In the short term, it is possible for alternative and traditional asset classes to fall in tandem although at varying rates.

Should you invest? Before adding any investment to your portfolio, it is important to ascertain the investment's expected risk and return potential, and how it fits in your existing portfolio.

It is human nature to fall in love with what is hot, as evidenced by the technology bubble in the late 1990s. However, an investor should not put all his eggs into one basket. Diversification helps you balance the risk with the returns over the long term, as it is difficult, if not impossible, to time the market and get it 100 per cent right all the time over the long term.

Clients should be taken through a financial check-up or wealth planning session, to thoroughly assess their risk appetite, investment objectives and horizon, before making any recommendations.

A bank is also likely to have developed model portfolios that can be tailored to achieve an optimal level of diversification for each customer based on his risk and investment profile.

For example, an investor who is heavily invested in tactical instruments (eg. emerging market equities, single country funds) may wish to consider adding lower-correlated investments (such as hedge funds) to their portfolio to help lower the overall volatility.

In the hypothetical example below, the losses of the investor whose portfolio included hedge funds and Reits were minimised compared to a portfolio entirely in Asian equities.

Investors should be mindful that alternative investments come with a number of specialised risks. Hedge funds, for example, come with the risk of potential losses due to leveraging, short selling, and reduced transparency and liquidity compared to traditional mutual funds.

Potential investors should read the fund prospectus or offer circulars carefully, and understand the limitations of the product. Investors should note that hedge fund fees are usually slightly higher than traditional mutual funds due to the higher levels of active management involved. You should therefore look at the performance of the fund net of fees. Higher fees may not be a concern if the net performance is generally positive.

As with all mutual funds, it is important to evaluate an alternative investment's performance over a full market cycle, that is, five or 10 years and not just in a bull or bear market. In general, alternative investments are just that - an alternative to, but not a replacement of, traditional mutual funds. Investors may therefore want to limit these to no more than half of their investment portfolio.

Investors should also be mindful that some hedge funds might require higher investment minimums, and may lock your money in for a period of time (three to five-year commitments are quite common). Some types of alternative investments may also require an investor to meet a minimum net worth and income requirement.

Ultimately, while investors can choose to add alternative asset classes to diversify their portfolios, it is best to first consult a financial adviser for guidance.

The writer is head of investments, Citibank Singapore

The options

Of the various alternative asset classes, base metals like gold and copper have captured recent investor interest due to demand from fast growing economies like China. In the near term, while there may be a softening of metal prices (with the exception of gold), Citigroup analysts continue to have a positive outlook on mining companies amid ongoing corporate consolidation and tight supply. On the other hand, there is a risk that demand may fall over the longer term, as high prices force manufacturers and consumers to seek substitutes.

Another popular alternative asset class is hedge funds. As hedge funds are subject to less regulatory controls than other types of funds, they have historically been available solely for institutional investors or investors with high investment minimums (eg. $1 million). However, as hedge funds have the potential to benefit from market inefficiencies and emerging trends, regardless of the direction of securities prices, demand for this class of asset has grown significantly in recent years.

Real estate investment trusts, or Reits, have also become more popular in the past year as they generally provide investors with an alternative exposure to property, and offer good yields, regular income and liquidity

» Understanding your options
» Putting money in warrants
» When ill health strikes
» Investors still taking a shine to gold
» The alternative view
» Holistic approach to investing
» Diversifying into foreign currencies
» Greater accessibility for smaller investors
» Cashing in on en bloc fever
» A closer look at structured deposits
» Retirement dreams
» The lowdown on home loans
» Opportunity for greater gains