Making the Case of Having Alternative Investments in Portfolio

In the July issue of Financial Planning magazine, there’s an article about including alternative investments such as energy, precious metal, real estate, etc, in portfolio and how they will impact the overall returns of portfolios with and without these assets. This isn’t the first time I read papers that argue the case of having commodities, even a small percentage, in the investment mix. In fact, some of the modern portfolios have quite a significant portion of the assets in real estate and precious medal and the benefit can be summarized as reducing risks and increasing returns.

Inspired by the article, I decided to take a look at what the performance would be, with and without alternative investments, using Vanguard funds for different asset allocations. The article, Quasi-Commodities, by Carig Israelsen, considered two asset allocation plans: a conservative allocation with 60/40 equities/bonds allocation and an aggressive allocation of 90% and 10% in stocks and fixed income securities, respectively.

Components and their performances

The Vanguard funds I’m using are Vanguard S&P 500 (VFINX), Vanguard Total Bond Market Index (VBMFX), Vanguard REIT Index (VGSIX), Vanguard Energy (VGNEX), and Vanguard Precious Metal and Mining (VGPMX), representing large-cap stocks, bonds, REIT, energy, and precious metal, respectively, and the period under consideration is from January 1, 1997 to January 1, 2007. I’d like to use a longer time frame for the study, however, one of the funds has historical data only after 1996 on Yahoo Finance. To check the performance of each allocation schemes, I assume I have $10,000 to invest on January 1, 1997 and no additional purchase will be made throughout the 10-year period. However, all dividend distributions of each fund are reinvested. Therefore, the change of number of shares owned is strictly due to dividend reinvestment.

The following table shows what $10,000 on January 1, 1997 became on January 1, 2007 if the money was 100% invested into each fund. It’s a big surprise to see that S&P 500 (VFINX) is actually the worst performer, with a gain of only 167% over the past 10 years. On the other hand, the bond index fund (VBMFX) has a huge gain of 291% as dividend reinvestment has grown the number of shares from 1841 on January 1, 1997 to 3992 10 years later, though the price of the fund only changed moderately.

Symbol Start/End date Share price No. of shares Market value Gain
VFINX 1/2/1997 $58.13 172.0282 $10,000
1/3/2007 $129.91 205.9671 $26,757 167.57%
VBMFX 1/2/1997 $5.43 1841.621 $10,000
1/3/2007 $9.8 3993.369 $39,135 291.35%
VGSIX 1/2/1997 $6.6 1515.152 $10,000
1/3/2007 $25.45 3393.128 $86,355 763.55%
VGENX 1/2/1997 $13.68 730.9942 $10,000
1/3/2007 $61.52 1282.788 $78,917 689.17%
VGPMX 1/2/1997 $7.33 1364.256 $10,000
1/3/2007 $26.93 2303.987 $62,046 520.46%

The result of VBMFX seems to be unbelievable, so I double checked my calculation. What’s unique of this fund is it had about 5 cents per share dividend distribution every month. With more than 1841 shares to begin with, each month the fund could add more than 15 shares and as the number of shares grew, the dollar amount from each distribution got bigger and bigger and more and more shares were purchased. If without the dividend reinvestment, the total market value would only be $18,047 after 10 years, close to the total return of the fund on Morningstar fund performance page. For each fund, the annual dividend payout and the ratio to the share price at the beginning of the year is as follows:

  • VFINX: 1997 – $1.91 (3.29%); 2007 – $2.14 (1.64%)
  • VBMFX: 1997 – $0.644 (11.86%); 2007 – $0.468 (4.96%)
  • VGSIX: 1997 – $0.77 (11.67%); 2007 – $1.06 (4.17%)
  • VGENX: 1997 – $1.65 (12.06%); 2007 – $2.467 (4.01%)
  • VGPMX: 1997 – $0.13 (1.77%) ; 2007 – $3.025 (11.24%)

Asset allocation plans

Now, let’s see how a portfolio with these funds as components will perform. The asset allocation plans, as mentioned above, have 60/40 and 90/10 allocated to stocks/bonds. First, if I take the stock/bond approach without including any alternative investments.

Symbol Asset Allocation Market Value Asset Allocation Market Value
VFINX 60% $16,054 90% $24,081
VBMFX 40% $15,654 10% $3,913
VGSIX 0% $0 0% $0
VGENX 0% $0 0% $0
VGPMX 0% $0 0% $0
Market value $31,708 $27,994
Gain 217.08% 179.95%

Because of the extraordinary performance of the bond fund, having a large portion of VBMFX (40%) produced better overall return for the portfolio than the one with only 10% invested in bonds.

If I add alternative investments into the mix while maintaining the percentage of bonds (40% and 10%), the change in terms of market value after 10 years is remarkable, which can be seen from the following table.

Symbol Asset Allocation Market Value Asset Allocation Market Value
VFINX 45% $12,040 60% $16,054
VBMFX 40% $15,654 10% $3,913
VGSIX 5% $169 10% $339
VGENX 5% $3,945 10% $7,891
VGPMX 5% $3,102 10% $6,204
Market value $34,912 $34,403
Gain 249.13% 244.03%

For each asset allocation, adding REIT, energy, and precious metal helped boost the portfolio’s return by more than 10%.

Conclusions

Though the results from the above analysis may be skewed because of the strong performance of sectors such as real estate, precious metal, and energy in the past decade (the following chart shows the performance comparison of the 5 funds used), there’s little doubt in my mind that the sector funds should have a place in the portfolio, even at a small percentage (as the 15% alternative investments in the above example).

compare.png

In addition, dividend reinvestment played a key role in the growth of each fund. If all distributions are taken as cash, the market value of each fund will be significantly reduced: VFINX: $22,348, VGSIX: $38,560, VGNEX: $44,970, and $36,739.

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10 Responses to “Making the Case of Having Alternative Investments in Portfolio”

  1. Kujimon |  Jul 03, 2007 at 11:49 pm

    Great article. I’ve just recently started adding commodities and REIT to balance my portfolio as well. For commodities I’m using ishare’s ISG ETF. It’s based on the S&P GSCI index which track commodities. Seems pretty diverse as it includes Energy, metals, Agriculture & Livestock.

    I’m amazed at what effect the reinvested dividends had!

  2. vijay |  Jul 04, 2007 at 12:34 am

    how do u calculate the effecient allocation of alternative assets in case the risk & return data is not available . this may be due to past price series not being available for such an alternative asset class e.g. private equity

  3. Sun |  Jul 04, 2007 at 12:41 am

    Kujimon: In fact, GSCI index was used in the Financial Planning paper as the benchmark for the study. The index itself has quite broad coverage of commodities, but I feel the portion that’s invested in precious medal is a little small (less than 3%). A larger investment in precious medal could produce better return.

    Yes, the dividend reinvestment is really amazing, especially for the case of the bond fund. Without the reinvestment, the fund’s return is much lower.

  4. Sun |  Jul 04, 2007 at 12:50 am

    Vijay: Actually, I don’t have any risk/return data as I feel the raw data isn’t available for retail investors (unless through some kind of subscription services) and that’s the reason I usually funds whose historical price data are available to public. The only risk/return data I can find is on Marningstar’s website (for each fund). However, if you have the raw data of a fund and the data of the index that the fund is tracking, calculating the fund’s standard deviation can give you a sense of the fund’s risk.

  5. sucellus |  Sep 21, 2007 at 1:52 pm

    Great information!

    I’m interested in doing a similar analysis with other funds and allocation plans. How did you go about making these calculations?

  6. Donny Gamble |  Nov 06, 2008 at 2:08 pm

    A great idea that more and more people need to start thinking about having is a self directed IRA. This let’s you diversify your investment portfolio into one single location.

  7. Tim |  Nov 07, 2008 at 6:36 pm

    I guess the question is what is the difference between buying an array of sector funds versus a balanced fund? precious metals are problematic to me, because they have been flat forever except the unjustified spike within the past 1.5 years.

  8. Finance |  Nov 10, 2008 at 6:56 am

    Yes, invest in a portfolio of financial securities can diversify or reduce the overall risks, one can consider investing in different types of products like bonds, etc.

  9. Moneymonk |  Nov 12, 2008 at 6:25 pm

    Some of those funds are reopening to new investors

    http://www.moneymonk.net/2008/11/vanguard-oakmark-reopen-attractive.html

  10. kitty |  Nov 17, 2008 at 12:32 pm

    I did put a little of my 401K into a commodity fund recently. Also a little in investment grade bond fund since bonds appear to be a good deal now with the credit crisis driving yields up and values low. I also bought 10K worth of municipal bonds (not funds, actual bonds- 5K of AA NYC bond with tax free yield to maturity of 5.3% and 5K of AAA NYC tax receivable bond with yield-to-maturity of 5.36%). The reason I got a better deal on a AAA bond is that I bought it a couple of weeks earlier when the credit crisis was worse. I plan to buy more bonds this week – undecided about municipal or corporate – when one of my CDs matures.

    A word of caution about bond funds. Don’t confuse them with individual bonds. Individual bonds are fixed income investments: they come with a fixed coupon rate and a “promise” to return to you your principal at maturity. While the value of individual bonds on the secondary market goes up and down (except for government I and EE bonds, but these are a different story), you always have an option of waiting till maturity when you’ll get your money back unless bond issuers defaults. Bond funds, on the other hand, are NOT fixed income investments. Bond funds include many bonds, each with different maturity date. When you get your money back from the bond fund you essentially sell your bonds at whatever the current market price is on the secondary market. So you may lose money not only when there are defaults, but also when all bond values are down. Bonds tend to lose value a lot when the interest rates go up. While bond funds may offset this with the ability to invest in new bonds that offer higher returns as older bonds mature, it may take longer to recoup the money.

    Some people mistakenly think that the case of individual bonds vs bond funds is the same as individual stocks vs mutual funds. In fact, the bonds case is a bit more complex. In some respect bond funds may be riskier than individual bonds, especially if you keep to high quality bonds. There are pros and cons in both bond funds and individual bonds, but former being less riskier than the latter is not one of them.