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Once a pariah of the mainstream investment world, so-called “alternative” investments have become a favorite of investment managers. As usual, the recent excellent performance of investments in this category has attracted many new investors.

Attracting private equity, hedge funds, real estate, and even commodities, alternative investments offer a wide variety of assets that have been performing at or above investor expectations.

This group of investments is commonly defined as real estate (commercial or residential), energy investments, venture capital funds, and even precious metals companies.

The problem comes from the wide diversity of choices which often confuses individual investors, making it difficult to decide just how to build their portfolios. These new multiple alternatives come in different sizes, many of which are available to investors with limited liquid investment dollars.

The less investor sophistication, the higher the confusion factor. The recent growth of exchange traded funds and foreign exchange funds has further widened the marketplace.

Exchange Traded Funds (ETF’s) are attractive because of the nature of alternative investments. These investments are more difficult to trade easily, unlike stock shares, bonds, or other recognized vehicles, which makes alternative investments potential problem investments for mutual funds.

The often constant mix changes of mutual funds dictated by return expectations do not lend themselves to alternatives. Since ETF’s normally operate with a fixed number of shares, they appear to be more suited for alternative-laden portfolios.

Hedge funds, long considered the leader in alternative investments, and once available to only high-net worth investors, have become much more accessible to the smaller investor recently.

Regulators in throughout Europe are not thrilled with this development but continue to allow smaller investors in increasing numbers to purchase “pieces” of hedge funds, called “funds of funds.” These “pieces” may contain slices of multiple funds which use different investment strategies.

The theory is that this better protects the smaller investor with diversity instead of using one of the many “single strategy” funds, which by definition, carry a potentially much higher risk. These vehicles still target the high net worth investor because of these risks.

Alternative investments have become popular but how and why did they become alternatives in the first place? Stocks and bonds have long been considered the staple of the investment market.

Other investments, for instance many commodities, have equaled or bettered the performance of the stock/bond category. Just thirty years ago, gold, by itself, severely out performed all conventional investments.

Since the new millennium began, alternatives like private equity, various commodities, and, certainly, real estate investments have continually out performed most other options.

Yet, it is this historic cyclical performance trend, sometimes excellent and other times, very poor, causes them to be classified as alternative investments. Unlike stocks and bonds, which tend to attract a fairly consistent level of investment, alternatives generate large dollars when they are “hot” and tend to lose major investment dollars after they trend down, as they always have done.

As always, investors have serious “copy cat” tendencies. As more universities and pension plans, with their conservative philosophies, have poured dollars into alternative investments, other institutional investors have stepped into the market.

A recent respected study indicated that the investment level of British pension plans in alternative investments has increased around 400% in twenty-four months! The expectation that alternative investments tend to show strength when the usual markets are weak has led some investors to use a “mix and match” strategy, which justifies their inclusion of alternatives in a conventional portfolio, projecting that returns will be higher than with portfolios containing only conventional products.

In this environment they also are willing to claim that the risks are lower because of this wide spread diversity.

Commodities are an excellent example of this philosophy. As most investors are aware, commodities are not investments for the faint of heart. Fortunes have been made and lost quickly in this market area. Economics 101 defines basic supply and demand theory and commodities reinforce this reality. They provide the highest returns when they are in demand and their supply is constant or declining. Even conservative fund managers justify including commodities in their portfolios, believing they will provide excellent profits just when their traditional investment mix needs them.

There is even a new term for these new portfolios: New balanced fund. Historically, managers changed the mix between stocks and bonds based on market trends. As stocks became more volatile, they would switch funds into the bond market, noted for stability.

When the trend began a reverse, dollars would be moved from bonds to stocks. This new attitude of diversity leads to the inclusion of alternative investments to provide the target goals of consistent profitability. They continue to try to keep volatility below allowed tolerances using a method heretofore considered off-limits.

The popularity of the idea of “absolute returns”, the goal of making profit regardless of the current market trends and conditions, has led to the use of alternatives to balance the ebb and flow of investment portfolios.