Alternative Options: The Advantages and Challenges of Investing Outside of Stocks and Bonds

Alternative investments have been gaining popularity in recent years, a trend that’s likely to continue following the sell-off in stocks and bonds. While “alternative investments” may sound foreign, it is simply a catch-all term for investments outside of stocks, bonds and cash, and it can include anything from venture capital funds focused on technology companies to financing solar projects.

“In a new market paradigm where fixed income and equity markets move in tandem, investors are turning to alternative investments for uncorrelated returns, diversification, income, inflation protection and impact investing,” says Whittier Trust Vice President and Portfolio Manager Jay Karpen.

According to RIA Intel, 82 percent of financial advisors surveyed at a Morningstar Investment Conference said they’re recommending alternatives to accredited investors. While the potential rewards for this type of investing can be alluring, Karpen cautions that it’s best to partner with a trusted professional.

“Investing in alternatives is not easy,” he says. “These are complex instruments with uncertain timing, liquidity and risk/return impact on your portfolio.”

Wealth advisors have a variety of reasons for recommending alternative investment vehicles, but it’s important to consider the following before diving in.

Complementing a Traditional Portfolio

Wealth advisors strategically invest in alternative assets to further a client’s goals and objectives. They can leverage these investments to improve risk/adjusted returns, diversification, cash yields and unique attributes, such as social and environmental considerations, which may not be available in public markets.

Recently, a Whittier Trust client was looking to build a diversified alternative portfolio of high-quality managers to complement their public equity and fixed income portfolio.

“We developed a plan to reallocate their growth equities into select managers to enhance their expected returns, diversification and tax efficiency while targeting lower risk and not allowing the unfunded manager commitments to dilute potential returns,” Karpen says.

A Matter of Access

While demand has increased for alternative investments, so has the supply of options. In fact, the data provider Pitchbook tracks over 30,000 venture investment management firms.

“The challenge is that there are so many managers, and the dispersion of quality is vast,” Karpen says.

While the top-tier managers tend to outperform public markets, average ones often underperform. A wealth advisor’s ability to identify and invest with high-quality managers is critical to success. This is particularly important in venture capital, where high-quality managers consistently produce top-tier funds.

Same Playing Field

Just because an investment is labeled as “alternative” does not mean it’s immune to the economic factors of traditional asset classes. For instance, private equity and public equity are both influenced by economic growth and market multiples (i.e. valuations) while public and private debt are both impacted by interest rates and the credit cycle. Wealth advisors should evaluate alternatives relative to public market equivalents to ensure the portfolio is achieving the best risk-return outcome and is not over-exposed to an economic risk factor. For example, you might not want to fund a private equity investment with public fixed income if it overexposes the portfolio to economic growth.

Overall, alternatives are much more complex than public securities. They can be subject to long lock-ups, capital commitments and limited liquidity windows. While they may generate significant short-term gains and ordinary income; they can also rack up expensive fees.

“Be careful about conflicts: Some managers compensate financial advisors for placing clients into alternative investments,” Karpen says. “This structure might not result in the best outcome for clients.”

Wealth advisors should be able to evaluate and justify these complications.

Smart Alternatives
Adding alternative assets can enhance your portfolio’s goals and objectives by offering higher risk-adjusted returns, diversification and cash yield. However, alternatives should be evaluated relative to their public market equivalents, and their portfolio contributions should more than compensate for the illiquidity, complexity and higher fees. Partnering with an unconflicted wealth advisor, who has access to top-tier alternatives and the expertise to evaluate them both on a standalone and relative basis to public securities, is essential for the best outcomes.

Members of the editorial and news staff of the Las Vegas Review-Journal were not involved in the creation of this content.