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Indexing for Dummies: Diversify With Alternative Indexes

- By Robert Abbott

Throughout his book, "Index Investing for Dummies," author Russell Wild focused on indexing for stock and bond investments. So far.

Alternative asset classes got his attention in chapter nine, as he looked at gold, property and other investment products.

Gold and other commodities

For millennia, gold has been the first choice or the first alternative for prudent investors, but holding actual gold could be challenging. That changed in recent years as third parties bought and held the precious metal. As a result, individual investors can simply buy an exchange-traded fund or mutual fund. Owning and holding an ETF is no more difficult than owning and holding a share of Apple Inc. (AAPL).

The same can be done with other precious metals and commodities, including silver and oil. But the author warned that owning a single commodity is dangerous. Volatility in single commodities can be extreme; if the trend heads down, capital could be wiped out.

Traditionally, commodity prices have not correlated with stock and bond prices, so they can help protect a portfolio when markets take a deep dive. Wild wrote, "If you're going to invest in something that holds its own in bad times for the major financial markets, commodities may be a good choice."

Still, Wild recommended that the allocation to commodities be small, perhaps 5%. He also recommended they be rebalanced regularly, which may allow slightly better returns. And, keep your expectations in check; with relatively rare exceptions, commodities won't do much better than the rate of inflation. Of course, many investors buy gold in hopes of cashing in on one of those rare exceptions when prices spike.

One other important note: the author wrote investors should choose index funds that include multiple commodities, not just one. Avoid niche products that invest in just one commodity, whether that's gold, silver, oil, grains, livestock, copper or nickel.

Real estate

While some investors prefer buying individual residential or commercial property, most now use real estate investment trusts, or REITs (Wild helpfully points out that REITs rhymes with Keats, the poet). Owning a REIT has several advantages over owning individual real estate properties, including the obvious one of not being called out to fix the plumbing.

Most importantly, though, REITs allow instant diversification. Buying into a REIT means buying into dozens, if not hundreds or thousands, of different properties. They come in multiple flavors, including rental properties, shopping malls, health care facilities and hotels. Using ETFs or mutual funds, investors can buy into narrowly or broadly-based REITs.

When Wild was writing this chapter in mid-2008, he noted investors had been buying REITs for the wrong reason: chasing high returns. He emphasized investors should invest in REITs for their diversification power, not their recent performance. As we now know, his warning was prescient and well placed.

That's the world of REITs in a broad context. Wild also offered some thoughts on the "true nature" of them:

  • REITs, when owned through ETFs, are simply a type of equity. They behave much like stocks in the market and "The price of REITs, and their return to investors, is subject to the same irrational exuberance and despair that other stocks are."
  • They pay high dividends for a structural reason. That is, they enjoy special tax considerations and, in return, must pay out at least 90% of their income, as dividends, to shareholders. In the years leading up to 2008, they averaged 4% to 7%, much more than the average of 1.6% available from S&P stock funds.
  • But those high dividends come at a price to investors, at least for those whose investments are not in tax-advantaged funds. Dividends mean taxes, and REIT holders must pay. Alternatively, we might say REITs are not tax efficient.
  • As many Americans found out in 2008, there is such a thing as too much real estate. Investors with a large stake in their own homes or rental properties will be buying more of the same if they invest in American REITs. Instead, they should invest in an asset class that is not correlated with their homes.
  • International REITs can provide that diversification. Normally they do not correlate with American stocks, including REITs.
  • REITs are just one way to diversify a portfolio because they do not necessarily mimic the broad stock market, but there are other sectors that offer similar diversity. Energy, utilities and consumer staples also have limited correlation with the S&P 500 and may be better sources of diversification. That's especially true for investors who cannot shelter their investments from taxes or already have a significant stake in real estate.

Low cost is extra important when investing in REITs because of their exposure to taxes through dividends. Even normally tax-efficient index funds can be costly if they hold a high proportion of REITs. As with gold and commodities, REITs should get a minor allocation; Wild suggested 10% to 20% as generic guidelines. Specific guidelines would require much more information, including the room available in tax-advantaged accounts.

"Currency quackery"

This is the first of several "unorthodox indexes" and refers to the practice of buying and selling currency ETFs. Wild wrote, "I'm not even sure that these currency ETFs qualify as index investing. But they're being advertised as index funds, and most people think (rightfully so) that ETFs are index funds, so I suppose I need to comment both on the funds and the advertisements. (Note to advertisers: You aren't going to like what follows.)"

I think the tone of those words tells us everything we need to know about investing in currencies. Leave this field to the specialists.

Private equity

This refers to taking an ownership stake in a company that is not publicly traded, one still owned by relatively few people. Their attraction comes from the potential for above-average returns, which in some cases can be spectacular. However, there is no guarantee and many of these companies also fail.

In recent years, institutional investors, including pension and hedge funds, have made major investments in this asset class. Individual investors can get a piece of that action by taking stakes in mutual funds or ETFs that invest in the class.

Preferred shares

Think of a cross between a stock and a bond when you think of preferred shares. They offer higher returns than bonds, but not as much as stocks. They offer more protection than conventional stocks in the event of bankruptcy, but less than bonds. Generally, individual investors opt to buy stocks and bonds, while some professional fund managers buy preferreds for strategic purposes.

Covered calls

Some funds aim for above-average returns by buying a stock and then selling a call option on it. This provides a third source of revenue from a stock. Making money with them in uptrending markets is tough, but they can be effective in flat or downtrending markets. As with most things that involve stock options, covered calls demand an extra level of knowledge and attention.

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

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This article first appeared on GuruFocus.