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The Advisor’s Guide to Alternative Investments: Benefits and Risks

The Advisor’s Guide to Alternative Investments: Benefits and Risks

March 19, 2018

As advisors, we are constantly seeking ways to better diversify and increase the return of our portfolios. In addition, we need to be knowledgeable about the many different investment products, so we can provide the best advice for our clients.

“Alternative investments” or simply “alternatives” are terms used to describe a series of investment products that can sound exciting and new to your clients. Clients can easily be caught up in the hype but as advisors, it is important to help them understand what alternative investments are, their benefits, and the risks.

“Alternative Investments”

Alternative investments include any investment that is not a traditional long-only position in stocks, bonds, and/or cash. While there are a plethora of alternative investments, they are generally placed into four categories: real estate, commodities, hedge funds, and private equity funds.

A few characteristics common to most alternatives include active management, low liquidity, limited regulation, higher fees, limited or no access to historical price data, and low transparency. In addition, portfolios may be highly leveraged which increases both returns and losses. For these reasons, when researching alternative investments, the selection of the portfolio manager is very important.

Benefits of Alternative Investments

One of the main benefits alternative investments provides your portfolios is increased diversification. For clients with large enough assets, finding enough diversity in traditional markets can be a challenge.  Alternatives offer a solution to this problem by providing access to asset classes that are not available in traditional markets. Increasing not only the number of investments but also the type of investments is key to building a well-diversified portfolio.

Historically many of these assets have had lower correlations to equity and bond markets. Low correlation means alternatives can be used to hedge against inflation, generate income when bond yields are low, or increase returns when equity markets underperform. Increasing diversification and simultaneously decreasing correlations may substantially reduces risk in your clients’ portfolios, this ability to reduce risk makes alternatives an attractive addition.

An often touted benefit to alternatives is the theory that a manager’s individual skill can result in higher returns. Portfolio managers often seek inefficient markets where their skill as a manager can add to the bottom line of the fund. In these types of markets, a manager’s connections, insights, and access to data can have a real impact on the performance of the fund. In combination these three advantages - increased diversification, lower correlations, and the possibility for higher returns - make a compelling argument to reserve a portion of your clients’ portfolios for alternatives.

Risks of Alternative Investments

While the benefits are attractive, alternative investments are not for everyone and carry their own set of risks. Because alternatives employ unique strategies and operate in less liquid markets, often there are restrictions on cash withdrawals. Some investments will only allow a small percentage of the fund be withdrawn during a given period (e.g. 5% of total assets quarterly), while others may charge a penalty for any withdrawals before the fund is closed. This means an investor may not be able to access the capital invested for months or even years.

In addition to low liquidity, investors may also experience high costs and confusing fee structures. For example, a classic hedge fund fee structure is “2 and 20.” This type of fee structure means an investor will pay a 2% management fee on their investment plus a 20% incentive fee from any gains generated by the fund. This is just one example of many different fee arrangements. Complicated fees are not only confusing but can also make comparing funds difficult. As an advisor, it is essential to fully understand these fee structures and know the true cost to your client.

Another risk is increased correlations during bad economies. One of the main benefits of alternative investments is historically low correlations with traditional investments, however, there is evidence to suggest that correlations may increase during economic downturns. During times of recession, alternatives may perform poorly along with other investments and any leverage used in the fund will only magnify the negative returns.

In the end, the investment set aside to perform well during market downturns may end up intensifying losses. Clients should always be aware of the risks and have the ability to take on those risks.  

Alternative investments are products that are not made up of traditional long-only investments. These investments can be a key part of your clients’ portfolios. They can add diversification, lower correlations, and provide higher returns. On the flip side, they can be illiquid, expensive, and amplify negative returns during bad economies. Because of their inherent risks, alternative investments should be carefully vetted before making a recommendation.

As an advisor, it is your job to know the benefits and risks of any product you recommend. Once the benefits and risks are understood, you can then make the best recommendation for your individual clients. MSMF has a team that specializes in portfolio construction and is available to analyze your clients’ current portfolios or helps decide if a specific investment product is the right solution. Contact us at 314-677-2550.