21 Jul Are commodities and hedge funds right for me?

 Q. I know I should have alternative asset classes in my portfolio. Where do commodities and hedge funds fit in? I have about $2 million for retirement and I’m 57.

A. You’re right that alternative asset classes should be a part of your portfolio. They’ll help to lower your overall risk through diversification, and hopefully edge up your returns.

It can be tricky to include commodities and hedge funds in your portfolio.

Commodity investing, for starters, is a whole different animal, said Brian Power, a certified financial planner with Gateway Advisory in Westfield.

“Most successful commodity investors spend all of their time in that space,” he said. “It’s an area of investing you for sure would want to outsource to a money manager.”

Power said a mutual fund would be the way to go so you can get the professional money management and have the benefit of multiple commodity types to invest in.

Stephen Craffen of Stonegate Wealth Management in Oakland, said commodities are also important because they improve diversification and also provide a hedge against high inflation, but he no longer considers them an alternative asset class.

“We would suggest investing 3 to 7 percent in commodities, using a mutual fund that invests in a broad basket of commodities that matches the Bloomberg Commodities index,” he said.

On to hedge funds.

Power said for many hedge funds investments, one must be an “accredited investor.”

“The purpose of this designation is to protect potential investors from risk,” Power said. “The assumption underlying accreditation is that individuals or organizations who qualify will have sufficient financial sophistication to understand and take on the risks associated with certain investment offerings.”

Power said in the U.S., for an individual to be considered an accredited investor, they must have a net worth of at least $1 million, not including the value of their primary residence, or have income of at least $200,000 each year for the last two years with the expectation of earning the same this year.

Hedge funds come in all shapes and sizes and you need to educate yourself about which types of hedge fund strategies make most sense for you, Power said.

The most common strategies include market neutral and equity long short, Craffen said. Both strategies involve purchasing securities — long positions — and selling them short — short positions.

“The manager may make the long positions equivalent to the short, in which case the fund is `market neutral,’” he said. “They may have a `directional’ position by having one category higher than the other in dollar amount (long/short).”

He said funds like those tend to exhibit less volatility than a straight, long only fund.

The returns you’ll see from a market neutral fund and a long/short can be very different, Craffen said.

“Market neutral funds earn money on the cash they receive from selling stock short and therefore the main driver for their return is the return on cash,” he said. “This return typically consists of money market rates plus the difference in return of the long positions from the short, which is highly correlated to the manager’s expertise — known as ‘manager alpha.’”

Craffen said market neutral funds should have very low correlation with any index. Long/short funds will generally provide more return because the positions do not offset each other, but they will also have the potential for greater return while still being less sensitive to a market index.

He said the manager’s expertise is critical to the success of this type of strategy.

“We believe these do have a place in someone’s portfolio since they can enhance diversification,” he said.

Investors also need to realize the management fee for these funds is much higher than those of typical mutual funds.

“We’ve seen some as high as 2.5 percent annually. That means the manager does have a high threshold to cross for an investor to see the benefit of the strategy,” he said. “We would suggest you carefully screen the managers and possibly invest anywhere from 2 to 8 percent in these types of funds.”

One good way to start out with hedge funds investing is to use a “fund of funds” strategy, Power said.

“You invest in a fund that then takes your money and diversifies it among multiple hedge funds,” he said. “You can get the benefit of 1) the research of the hedge funds being done for you 2) buying into multiple funds at once and 3) getting pricing benefits by investing along with other people’s monies.”

You might be able to get access to a hedge fund that would require a very large minimum investment — like $1 million — if you went directly to the fund, but a “fund of funds” requires a much lower minimum, Power said.

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This story was first posted in July 2015.