Making the Case of Having Alternative Investments in Portfolio

In the July issue of Financial Planning, 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 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.

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.

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.

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).

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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