ALTERNATIVE

INVESTMENTS
Understanding their role in a portfolio

WHAT ARE ALTERNATIVE INVESTMENTS?

What role can they play in todays approach to portfolio
planning and asset allocation?

While opinions vary on exactly what makes an investment alternative,

there is growing consensus that investors may want to consider alternatives
in their asset allocation strategies. Alternatives history of adding
diversification, enhancing return and improving the risk profile of a portfolio
has sparked dramatic growth in these investments in recent years.
In this guide, well take a closer look at what alternatives are and why they
may be appropriate in investor portfolios. But first, lets look at some of the
reasons for the increasing interest in alternatives.

WHAT IS A NORMAL MARKET?

Ask most people what they expect the stock market to return, and they may
tell you around 8%. And over time, returns have averaged around that level.
But the ride has not been a smooth one. Markets have gone up and down.
Andas we all learned the hard way in recent yearswhen markets go down,
the fall can be significant.

Tug-of-war: volatility vs. returns

Many investors are hanging on to the

2,500

belief that, if they can stick with the

market long enough, they can capture

2,000

the returns theyve grown to expect. But

how long is long enough?

1,500

Others hang back, afraid to get into

1,000

Annualized return 8.31%

the market because of the losses that
burned them in recent years.

500

0
1975

1979

1984

1988

1993

1997

2002

2007

2011

Monthly price returns for the S&P 500 19752012

So what should we expect from the marketa relatively smooth ride or a rocky one?

PREPARING FOR MARKET STORMS

Investors should be prepared for both smooth and bumpy rides. If you look at
the bigger pictureover 100 years of history for the U.S. stock marketyou can
see that the type of volatility experienced during the 2000s is not unprecedented.
The 1910s, 30s and even the 80s also had periods of high volatility.

The bigger picture:

Market storms come in cycles

The weather offers a good analogy. In Miami,

for example, the average temperature is a
very pleasant 76 degrees, and the sun shines
249 days a year. But dont forget that Miami
gets hit by a hurricane about every four years
and a major hurricane about every 10 years.
If you lived in Miami, you wouldnt build your
house just for sunny weather, would you?

100%

91%

91%

85%

80%

80%
60%
40%

Like the weather, markets go through

20%

pleasant and unpleasant periodsbull and

bear marketsand periods of high and low
volatility. We know storms will come, we just
dont know when they will hit.

0%
1900

1910

1920

1930

1940

1950

DOW JONES INDUSTRIAL AVERAGE 19001957

1960

1970

1980

1990

2000

S&P 500 19582012

Monthly volatility for DJIA and S&P 500 19002012

That means you may want to ensure your

investment portfolio is properly equipped.

Like building a house to withstand a hurricane, preparing a portfolio to weather

market storms is a critical step toward meeting long-term investment goals.
2

2010

A BETTER PATH
Its not always 76 degrees in Miami, and portfolios dont

averages support that hypothesisboth investors have

always return 8% per year. There are good years and

an average return of 6% over the three-year period, as

bad years, and the timing and magnitude of the good

can be seen in the chart.

and bad years make all the difference. The volatility of

portfolio returns can have a meaningful impact on the

But investment returns dont average; they compound. It

outcome for an investor.

takes a much bigger gain or a longer period of gains to

recover from a big loss. On a cumulative basis, Investor

Take the simple example shown below. Investor A

A has a return of 19.1%, or 6% annualized, while Investor

receives a 6% return each year for three years. Investor B

B has a cumulative return of only 12.3%, or 4% annualized

receives a big gain in the first year, followed by a big loss

one-third less than Investor As return.

in the second year, then another gain in the third year.

Wouldnt you rather have a smoother ride and potentially

Which portfolio would you prefer?

a higher annualized return? One way to help smooth out

Investor B may think his gains in years one and three

returns is through diversification. The objective is to

more than made up for his loss in year two, and that his

have something in your portfolio that is doing well at any

portfolio performed just as well as Investor As. Simple

given time, in any kind of market.

Investor As smoother ride led to a better return

Investor A

Investor B

For illustrative purposes only.

30%
19.1%
6%

6%

8%

6%

12.3%
6%

6%

6%

4%

-20%
Year 1

Year 2

Year 3

Simple Average Return

Cumulative Return

Annualized Return

TRUE DIVERSIFICATION?
CORRELATION TELLS THE STORY
1.0

1.00

0.8

0.5

For decades, investors have used a range of traditional asset classes to

0.3

diversify their portfolios: domestic stocks, international stocks, emerging

0.0

market stocks, and bonds. But how much diversification do these asset
classes really provide? The concept of correlation sheds some light on
-0.4 this.
-0.5

Correlationa statistical measure of how

two variables relate to one anotheris a way

Asset A
1.0

1.0

different investments with a correlation

of 1.0 will move in exact lockstep,

Asset C
(Low)

Better diversification

Asset B
(High)

0.5

other, and investments with a correlation

Asset C
(Low)
0.3

of -1.0 will move in opposite directions.

The higher the correlation, the lower the

Asset D
(Negative)

0.8

investments with a correlation of zero

will not move at all in relation to each

Asset B
(High)

Lower correlation

to measure the diversifying effect of an

investment when added to a portfolio. Two

Asset A

0.0

Asset D
(Negative)

diversifying effect; the lower the correlation,

the greater the diversifying effect. In other
words, to get a smoother ride, you need to
combine assets that dont all move

-0.4
-0.5

For illustrative purposes only.

in the same direction, to the same degree

and at the same time.

For example, if you were looking for a diversifier for Asset A in your portfolio, Asset C and
Asset D would be much better choices than Asset B.

IN DIFFERENT MARKETS,
CORRELATION CHANGES
For many years, combining a variety of equity asset

Time and broader trends have also led to a rise in

classes with varying correlations to the S&P 500, along

correlations. Take international stocks. With globalization,

with a healthy dose of U.S. bonds, did a good job of

correlations to the S&P 500 went from 0.47 in the

providing enough diversification for portfolios.

1980s to 0.54 in the 1990s to 0.88 in the 2000s.

What investors didnt anticipate is that during periods

Meanwhile, U.S. bonds have continued to provide

of market distress, the correlations of these traditional

diversification, especially during stressful times. However,

diversifiers would increasesometimes significantly.

in todays environment of historically low interest rates,

But thats exactly what happened. During the down

theres no guarantee U.S. bonds will continue to be

markets of the last two decades, not only did these

effective diversifiers.

traditional asset classes move in the same direction,

they moved more closely together. In other words, their

The truth is, you may no longer be able to rely on

diversifying effects broke downjust when they were

conventional diversification to meet your long-term

needed most.

goals. So what can you do to ensure your portfolio

can weather market storms?

Correlations rose in down markets (19882012)

Overall

Down Markets

Correlation to the S&P 500

1.25
1.00

1.00

1.00
0.83

0.75

0.87

0.75

0.85

0.73

0.79

0.50
0.25

0.18

0.00

-0.16

-0.25
Large Cap Stocks
(S&P 500)

Small Cap Stocks

(Russell 2000)

International Stocks
(MSCI EAFE)

Emerging Market Stocks

(MSCI Emerging Markets)

U.S. Bonds
(Barclays U.S. Agg. )

CONSIDER ALTERNATIVE INVESTMENTS

Alternative investments may be part of the solution. Alternatives can
refer to asset classes or strategies. Generally speaking, they are investments
outside long-only positions in the traditional asset classes of stocks, bonds
or cash. Many alternatives have a low correlation to traditional assets,
although thats not always the case.

Alternative asset classes include a variety of real, hard and

Alternative asset classes and strategies historically may

financial assets. Real, hard assets are tangible items

have been relatively difficult to access for the majority

that hold inherent valuelike real estate, commodities,

of investors, in some cases because of large investment

precious metals and collectibles. These asset classes

minimums and long lock-up periods for capital invested.

are often used for inflation protection. Financial assets

They also may have been less liquid or difficult to value

are intangible and include investments like currencies,

other factors that have made them alternative. But

volatility and private equity.

with new products increasingly available, many of these

barriers are starting to fall away.

Alternative strategies are investments that employ

investment techniques or processes that are not in the

While alternative investments can be used for diversification,

mainstream and are therefore considered alternative.

enhancing returns and managing risk in a portfolio,

they have their own risks that need to be considered

Many alternative strategies use leverage or short selling

when investing. For example, commodity prices are

in their efforts to generate returns. For example, a hedge

highly volatile, and investors may experience significant

fund may use long and short positions in equities or fixed

losses in a short period of time. Investments such as

income, while a managed futures fund may combine

futures are subject to a high degree of fluctuation and

long and short positions in commodities and currencies.

should be considered speculative. That said, what makes

alternatives attractive is that their risks are different from
those of traditional asset classes.

ALTERNATIVE INVESTMENTS
Alternative Asset Classes

Alternative Strategies

Alternative asset classes include

a wide variety of investment types
that provide exposure to real, hard
or financial assets.

Alternative strategies tend to use

unconventional approaches (like
leverage and short selling).

Real estate
Commodities
Precious metals
Currencies
Volatility
Private equity

Geared investing
- Leveraged investing
- Inverse investing
Long/short strategies
Market neutral
Absolute return
Convertible/merger arbitrage
Managed futures
Global macro

BEYOND THE CONVENTIONAL

For a portfolio of conventional investments with a high correlation to
the stock market, adding alternatives allows more possibilities to diversify,
enhance return and manage risk in a portfolio.

The chart on the following page shows a wide range

of an alternative investment is volatility, which has a

of traditional and alternative asset classes and

negative correlation to the stock market. Historically,

strategies with their correlations to large cap stocks,

when the S&P 500 experienced a down year, the

as represented by the S&P 500. As you can see,

volatility index generally moved in the opposite direction.

alternatives tend to have lower correlations than

traditional investments, providing better diversification

By going beyond the conventional and complementing

potential.

your core strategy with alternative investments, you

may have the potential to better diversify your sources

Lets look at an example, such as managed futures.

of return and manage risk. You also may be able to

These investments are generally composed of commodities

take advantage of changing market conditions and

and currencies, which tend to perform countercyclically

potentially profit from them.

to stocks and bonds and, when added to a portfolio,

could act as a hedge against inflation. Another example

BROADEN THE MENU

Diversify your sources of return

Return correlations 19922012

Traditional

1.00

1.00

Alternative

1.00
0.84

0.82

0.77

0.77

Correlation to the S&P 500

0.50

0.22
0.04

0.00

0.00
-0.10

-0.50

-0.72
-1.00

-1.00
2x Geared
Large Cap
Stocks

Large Cap
Stocks

Small Cap
Stocks

International
Stocks

Hedge
Funds

Emerging
Market
Stocks

Global
Bonds

U.S.
Bonds

Managed
Futures

Currency

Volatility

-1x Geared
Large Cap
Stocks

2x Geared Large Cap Stocks = 2x daily S&P 500; Large Cap Stocks = S&P 500; Small Cap Stocks = Russell 2000; International Stocks = MSCI EAFE; Hedge
Funds = HFRI Fund-Weighted Composite; Emerging Market Stocks = MSCI Emerging Markets; Global Bonds = Barclays Global Agg.; U.S. Bonds = Barclays U.S. Agg.;
Managed Futures = Barclay CTA; Currency = U.S. Dollar Index; Volatility = CBOE VXO/VIX (VXO from 12/19929/2003, VIX from 10/200312/2012); -1x Geared
Large Cap Stocks = -1x daily S&P 500

CONSIDER YOUR BALANCE

OF RISK AND RETURN
Investing has become much more challenging. The key to success in
todays environment is to build your portfolio to withstand the hurricane,
not just fair weather.
Traditionally, people believed that investing in higher-risk investments like
stocks would lead to higher potential rewards over time. But amid the
persistently high-volatility environment of the last decade, investors with
conventional portfolios composed primarily of stocks were not necessarily
rewarded for taking on more risk.

A broader menu

Adding variety

Selecting from a broader menu of investments including

Adding a variety of investments designed to provide

alternative asset classes and strategies might have

returns under different market conditions can help you

helped investors improve the risk/return dynamics of

prepare for the storms before they hit. The good news

their portfolios. Thats because alternative investments

is investors have access to a wider range of tools than

have risk and return characteristics that are different

ever before.

from those of traditional investments.

10

ARE ALTERNATIVES
APPROPRIATE FOR YOU?
At this point, you may be wondering where and how you can get access
to alternatives and if these investments are even appropriate for you.

Historically, alternatives were only available to institutional

Examine your portfolio

and high-net-worth investors because of limited access,

Are you as diversified as you should be?

low liquidity and lack of transparency, among other

D
 o you have enough investments that are likely to go

barriers to entry. But as alternatives have become more

up when your core portfolio is down?

popular, they have become more widely available, more

liquid and more transparent. Increasingly, investors

Your financial advisor can help you determine if theres

can get access to alternatives through mutual funds and,

a place in your portfolio for these investments and what

more recently, exchange traded funds (ETFs).

asset classes and strategies may be right for you.

Talk to your advisor about the possibility of adding

alternative investments to your portfolio.

11

GLOSSARY OF TERMS
Absolute return strategies seek to provide positive returns in

Hedge funds invest in a diverse range of markets and securities,

a wide variety of market conditions. This strategy employs

investment techniques that go beyond conventional long-only
investing, including leverage, short selling, futures, options, etc.

using a wide variety of techniques and strategies, all intended to

improve returns, reduce risk, or both.

Arbitrage refers to the simultaneous purchase and sale of an

Investors use leverage when they believe the return of an

investment will exceed the cost of borrowed funds. Leverage
can increase the potential for higher returns but can also
increase the risk of loss.

asset in order to profit from a difference in the price of identical

or similar financial instruments, on different markets or in different
forms. For example, convertible arbitrage looks for price differences
among linked securities, like stocks and convertible bonds of the
same company. Merger arbitrage involves investing in securities
of companies that are the subject of some form of corporate
transaction, including acquisition or merger proposals and
leveraged buyouts.

Commodity refers to a basic good used in commerce that is

Leverage refers to using borrowed funds to make an investment.

Managed futures involves taking long and short positions in

futures and options in the global commodity, interest rate,
equity and currency markets.

Precious metals refer to gold, silver, platinum and palladium.

interchangeable with other goods of the same type. Examples

include oil, grain and livestock.

Private equity consists of equity securities in operating companies

Currency refers to a generally accepted medium of exchange,

Real estate refers to land plus anything permanently fixed

such as the dollar, the euro, the yen, the Swiss franc, etc.

to it, including buildings, sheds and other items attached

to the structure.

Equity long/short involves using a combination of long and short

positions in stocks with the objective of reducing market risk and
enhancing return.

Equity market neutral is a strategy that involves attempting to

that are not publicly traded on a stock exchange.

REIT is a security that trades like a stock on the major

exchanges and invests in real estate directly, either through
properties or mortgages.

remove all directional market risk by being equally long and short.

Short selling or shorting involves selling an asset before its

Futures refers to a financial contract obligating the buyer to

bought. Typically, an investor borrows shares, immediately sells

them and later buys them back to return them to the lender.

purchase an asset (or the seller to sell an asset), such as a

physical commodity or a financial instrument, at a predetermined
future date and price.

Geared investing provides inverse or magnified exposure to

equities, fixed income, currencies and commodities.

Global macro strategies aim to profit from changes in global

economies that are typically brought about by shifts in government
policy, which impact interest rates and in turn affect currency,
bond and stock markets.

12

Volatility is the relative rate at which the price of a security (or

benchmark) moves up and down. Volatility is also an asset class
that can be traded in the futures markets. Tradable volatility is
based on implied volatility, which is a measure of what the market
expects the volatility of a securitys price to be in the future.

FIND OUT MORE

Understanding the concepts in this guide is an important step in deciding if alternative investments are appropriate
tools for you. ProShares.com offers additional educational materials and specific product information to help with your
decisions. Be sure you understand a funds risks and costs, as well as its underlying benchmark, before investing. You
should always consult the prospectus of any investment you are considering.

ABOUT US
ProShares, founded in 2006, offers the nations largest lineup of alternative ETFs. We enable investors to go beyond
the limitations of conventional investing and meet todays market challenges. We help investors build better portfolios
by providing access to alternative investments delivered with the liquidity, transparency and cost effectiveness of an
ETF. ProShares lineup includes Global Fixed Income, Hedge Strategies, Geared (leveraged and inverse), and Inflation
and Volatility ETFs. ProFunds was founded in 1997 and offers over 100 mutual funds.

To learn more about us and our growing family of alternative

investments, please visit ProShares.com and ProFunds.com.
13

All investing involves risk, including the possible loss of principal. ProShares and ProFunds entail certain risks, including risk associated
with the use of derivatives (swap agreements, futures contracts and similar instruments), imperfect benchmark correlation, leverage and
market price variance, all of which can increase volatility and decrease performance. ProShares are generally non-diversified. There is no
guarantee any fund will achieve its investment objective. Past performance is no guarantee of future results. Diversification may not
protect against market loss.
Carefully consider the investment objectives, risks, charges and expenses of ProShares and ProFunds before investing. This and
other information can be found in their summary and full prospectuses. Read them carefully before investing. For a ProShares ETF
prospectus, visit ProShares.com or obtain one from your financial advisor or broker/dealer representative. For a ProFunds mutual
fund prospectus visit ProFunds.com.
ProShares ETFs are distributed by SEI Investments Distribution Co., which is not affiliated with the funds advisors. ProFunds Distributors, Inc. is
distributor for ProFunds mutual funds.
Data source for charts: Bloomberg. Annualized stock market return based on the S&P 500s price index. Historical correlation statistics based on
the median of annual correlations rolled monthly. Source: Nations largest lineup of alternative ETFs: FRC, as of March 31, 2013.
2013 PSA/PFA 2013-4616