After spending several years working in the hedge fund world, followed by another (too long) period working as a lead ‘sell-side’ securities analyst for a securities brokerage house issuing ratings and price targets on securities in tandem with published research reports, my concern for individual investor’s welfare has markedly increased. That said, rumors of conflicts of interests are widespread and, in my opinion, have been quite valid for several reasons: (i) yes, analysts are often directly or indirectly pressured for positive ratings and lofty price targets on securities from investment banking departments (bonus incentive), from trading desks (to sell more), and from the companies covered (for better access); (ii) yes, brokers are often encouraged to actively trade accounts, often to the disservice of their clients; and, (iii) the system is fraught with inappropriate incentives, such as loads for mutual funds sold and poor price transparency on corporate bonds traded to customers in which the brokerage company handsomely profits from a ‘hidden spread’ – often 0.5% up to as high as 1.5% of value, on top of the commission.

But there are also many other pitfalls that average investors have fallen prey, such as actively trading their own accounts (from day trading to week trading now) or owning individual stocks without understanding diversification and exposure to sector or asset class risk. Indeed, research shows that over 90% of the return is attributable to proper selection of and allocation between asset classes, rather than stock "picking." In my opinion, the costs of trading or the risk of holding individual securities is simply dangerous without financial stock knowledge, ‘living and breathing’ the market and having diverse holdings. And if you use a broker, you must ask yourself these questions: Does your broker listen to the company conference calls? Does your broker have access to management? Do you think your broker wants to call you when one of your stocks just blew up with an accounting scandal, management corruption or disappointing earnings? Even if the brokerage house has analysts covering these matters, how involved is your broker in the process and is he brave enough to tell you to “sell & sell now” – not to mention was it appropriate for this stock or bond to be in your portfolio in the first place?

So what do you do? Do you buy a mixture of stock and bond mutual funds, and if so which ones and how much of each? The answer goes beyond your return requirement, risk tolerance, individual constraints (liquidity, taxes, income needs etc.) or even your age and size of financial assets. Granted, you must consider all these factors, but for the appropriate investment allocation to be correctly implemented, it should involve a degree ‘financial science.’ First, let me educate you on Modern Portfolio Theory.

Modern Portfolio Theory advocates a process first developed by Nobel Laureate Harry Markowitz, of selecting an optimal mix of asset classes based on past and forecast returns, volatility (i.e., standard deviation and beta values), and cross relationships (i.e. correlations and co-variances) that matches investor's quantifiable risk tolerance and gives them best possible rate of return. The goal is to have a low covariance portfolio based on each investors risk profile and return requirement so that the mean-variance is optimized (this is technical but I will make it clearer).

Investors used to take comfort in the notion that a portfolio diversified among domestic stocks and bonds would provide sufficient returns at the price of only moderate risk. There was good reason for this comfort. The lower the correlation, the better, which used to be exactly what domestic stock and bond investors experienced. From 1926 to 1969, the correlation between annual total returns for U.S. stocks and bonds was an attractive -0.02. Today, U.S. stock and bond markets mostly move in the same direction. This tendency is reflected in the correlation that was 0.23 from 1970 to 1980 and 0.58 from 1981 to 1998. This lack of diversification, in combination with attractive returns observed in other asset classes, drives the vigor with which opportunities in non-traditional (or alternative) asset classes have been pursued in recent years. (Ibbotson Associates 1999)

Reducing your portfolio's volatility can lead to higher returns. Consider two $10 million portfolios -- both of which earn 8% annual average returns. The annual returns of one swing from a 26% gain to a 10% loss, before falling 1% and rebounding 17%. The second is less volatile, with returns of 13%, 3%, 6%, and 10%. After four years, the less volatile one is worth 3.3% more, according to JPMorgan Private Bank. Why? The greater the downswings, the smaller the base upon which future earnings compound.

Here is the problem, many assets have become more correlated, markets have become more correlated and countries have become more correlated. This is especially the case in market crashes, technically termed as negative gamma events. That is the problem, just when you want your low correlated portfolio to constrain volatility it is at its greatest risk.

What is the solution? I suggest that you need to consider a host of new investment classes open to individual investors to mitigate this risk and these include hard assets, hybrid stock strategies and hedge fund strategies. This serves two purposes: First, these assets have very low correlation with bonds and stocks and each other and, Second, one flaw I find with Modern Portfolio Theory (MPT) is that it is predicated on markets being efficient. Let’s just say that there are strategies that benefit from inefficiencies in the market and by exploiting these anomalies the market gets more efficient – though, in my opinion not perfectly. Now by having a portfolio with substantial allocation to alternative class investments you benefit from low correlation attributes (lower risk) and in my opinion, these asset strategies partly offset MPT’s flawed paradigm that all markets are efficient.

In a December 2, 1996, article in Baron's, the newspaper had the following to say about Harvard Management Company's Chief Executive Officer:

"In the months after arriving from the Rockefeller Foundation back in 1990, one of his biggest decisions was to settle on diversification as a key theme. Relying on techniques of modern portfolio theory to get the best returns with lowest level of risk, Harvard needed to cut its exposure to publicly traded U.S stocks and bonds, and increase its investments in foreign stocks, commodities and private companies. The result: Right now the Harvard endowment has about only half its portfolio in U.S. stocks and bonds, versus about 75% for the typical university endowment."

Hedge funds, when added to a traditional portfolio of stocks and bonds, both improved returns and reduced risk. According to Van Hedge Fund Advisors, the average five-year net annual returns for the top 25% of U.S. Hedge Funds has been 20.4% for the first quarter of 1998 to the fourth quarter of 2002, compared to 5.6% for mutual funds during the same period. There are some new hedge fund products available for investment advisors to add to client portfolios that are quite unique which the average investors should consider. For example, there is a Hedge Funds S&P Index which has performed about 9% annually over the past five years that will become available to advisors next month. This product does not have a ‘qualified investor’ mandate

You can also synthetically design many of these types of hedge funds (though you can’t get the levered returns of private funds) through mutual funds, which are usually classified as ‘hybrid domestic.’ There is a merger fund, an arbitrage fund, long/neutral funds, short funds, bond arbitrage funds and convertible arbitrage funds available to the average investor. Among those with good track records, even during the bear market: the Hussman Strategic Growth Fund (HSGFX ) and the Legg Mason Opportunity Trust (LMNOX ).

Also, returns on private equity have averaged 13.8% a year over the past 20 years, compared with 11.7% for the S&P. You can't get into a private-equity fund without committing millions. But you can buy stock in a little-known type of closed-end fund, called a business development company (BDC), which is required by law to invest at least 70% of assets in private firms. Two of the biggest such companies, Allied Capital (ALD ) and American Capital (ACAS ), now yield 8.3% and 9%, respectively. Since its inception in 1960, Allied is up 17.9% a year, on average, while American has risen 21% a year since going public in 1997.

Turning to hard assets, these classes represent the ultimate in tangibility: real estate, precious metals, oil and gas, timber and other commodities. Cyclical and volatile, these investments have long been considered ideal portfolio diversifiers because of their relative low correlation to the stock market. Real assets may be divided into "hard" and "soft" assets. Hard assets are non-perishable real assets and include real estate and commodity-related assets such as energy (e.g., oil and gas), precious metals (e.g., gold and silver), industrial metals (e.g., aluminum and copper), and timber. "Soft" assets are perishable and consumable and include the commodities of agricultural products and livestock. The inclusion of hard assets can potentially improve performance. The higher efficient frontier is derived from an optimization that includes hard assets into consideration.

Like real estate, commodities (oil, lumber and other hard assets) have a decent record of negative correlation with stocks. Inflation sends the price of these hard assets up and it hurts the stock market. For example, the non-correlation between stocks and commodities was dramatically highlighted during 1973 and 1974 where stocks dropped 41% and commodity prices soared 114%. During the S&P's two worst declines during the past decade, managed futures recorded net profits. Also during September to November 1987, when the S&P 500 fell nearly 30 percent, managed futures rose 10%. And, the three-year return of Goldman Sachs Commodity Index (annualized from June 2002) is 10.91% - we invest in this class through the PIMCO Commodity Real Return, among other funds.

The results are startling -- the annualized return from January 1969 to September 1996 was 12.81%. This is actually higher than the S&P500 (11.24%), US small stocks (12.44%), and the EAFE (12.52%) for the same period. There is probably a few percent of survivorship bias built into this data, but the fact remains that the long term returns of precious metals equity and other common stocks are probably quite similar. Precious metals investing has another, more subtle advantage as well, it adds return and lowers risk to the overall portfolio if allocated correctly. Trouble is, there are so few good ways to tap into that hedge with liquidity, but among the few, we use USAA Precious Metals and Minerals fund. (source: Efficient Frontier, William Bernstein).

Additionally, the natural resources class typically moves independent of bonds and stocks. The Lipper Natural Resources Index fourth quarter return was 7.56%, with a 7.92% average return from inception in 1995. Among the many natural resource vehicles we use are the iShares Goldman Sachs Natural Resources Index fund, which is up 1% year-to-date, however, it is a bit to concentrated in energy so we usually blend this hard asset allocation with a couple funds. We also may want to underweight positions in one of these areas (e.g. energy) & may use more of Ivy Global Natural Resources since it has both more international exposure and lower energy positions (under 50%) relative to its peers. We also like the Oppenheimer Real Asset fund marked by its a low correlation, unique strategy, performance, no load, palatable expense & high bond positions as opposed to peer's using more equity. Like the other alternative classes, this investment class adds both return with less risk given it is appropriately applied to a portfolio.

Finally, we turn to one of the most common alternative classes, real estate investment trusts (REIT). We prefer REITs that have exposure to many different asset classes (office, shopping malls, retail & apartments) and broad geographic markets (not just one regional presence). Just as the bear market began in earnest in early 2000, REITs began their impressive winning streak. From March 31, 2000, to Sept. 30, 2002, Morningstar's REIT fund index gained 40.8%, while the S&P 500 suffered a devastating 43.7% loss. REITs finished near around the top 10% of all industry groups for the third year in the row. REITs also offer a dividend yield of around 7% or 8% with little worry that the dividend will be cut. Among the many funds we like is the Undiscovered Managers REIT.

Alternative asset classes are hard to understand and unless advisors understand the nuances of modern portfolio management, many advisors continue to steer clear from alternative investments, specifically hard assets. They look and say, ‘Gosh, look at the poor returns and volatility. How can that possibly help my client?" Except when you sit down and do the math, a 5% to 15% allocation of hard assets goes a long way in reducing overall portfolio volatility, while improving returns.

Now let’s pull this together. A typical investor who wants exposure to the overall market but lower downside risk must understand the upside will be capped. That is how it works since risk and reward are interrelated. A typical investor may be a client with no immediate investment income needs and doesn’t plan to retire for over 10 years and financial assets of $500,000. Given the earnings visibility remains poor, we are at war, fiscal and monetary polices have become more futile and we now face terrorism threats, our portfolio for a typical client may resemble this: (i) 30% exchange traded equity funds with different exposures to value/growth, market cap sizes and sectors (we are more value, and weighted in defensive sectors like consumer staples, consumer non-cyclicals, healthcare etc.); (ii) 35% alternative classes (arbitrage funds, long/short, neutral, opportunity strategies etc.); (iii) 12.5% hybrid fixed income (high yield, distressed, convertible bond); (iv) 12.5% hard assets (REITs, Commodity, Precious Metals & Natural Resources); and (v) 10% corporate bonds, mortgage backed-securities, TIPs & treasuries. Also remember that you should have exposure to international markets with a speck of emerging markets too, for both equity and fixed income allocation (we currently are overweight in countries like Canada, Australia and Thailand). Keep in mind on an ongoing basis we dynamically adjust these weightings based on sector, economic and asset class prospects in tandem with Modern Portfolio Theory. Use this roadmap as a broad guide, but read up on this subject first or seek advice from a professional that has the appropriate experience and academic pedigree to execute this approach.