How to Consider Alternative Investments as Part of Your Portfolio

Investment Strategy | Evidence Based Investing

 Jacob Malina By: Jacob Malina

In our Family Office practice, we field a lot of questions from clients who are interested in alternative investments. Perhaps you’ve also wondered whether you could improve on your investment portfolio by branching out beyond your core stock/bond asset allocations. With all the possibilities to consider, it’s a fair question.

As usual, the answer depends on you and your financial circumstances—plus what you mean by “alternative investments.” The term casts a wide net, so let’s start there.

What Is an Alternative Investment?

It might be easier to start by listing what are NOT usually thought of as alternative investments. Traditional asset classes typically include:

  • Stocks or bonds, held individually, or within mutual funds or ETFs
  • Cash or cash-like vehicles, such as CDs and savings accounts

If we consider everything else to be an alternative asset, that creates a huge, and ever-evolving range of possibilities—from hedge funds and private equity opportunities (including today’s blank-check SPACs), to cryptocurrency, artwork, commodities, real estate, and more.

Alternative Investments: Costs and Caveats

When evaluating whether to add alternative investments to your portfolio, it is important to consider your overall wealth and family goals. Following are a few factors worth digging into before diving into an alternative investment. (Hint: If the opportunity is so hot there’s no time to spare, that’s a red flag right there.)

Illiquidity risk and long lockup periods. One very real risk you run when investing in certain types of alternative investments is limiting your access to draw upon that capital as needed. If there is a downturn in the market and the fund is weakened by it, the fund manager may impose lockup periods, when investors cannot make withdrawals or redeem their fund shares. Even under ordinary circumstances, a private equity fund typically requires a 30–90-day notice for withdrawal requests.

Costly performance fees that can impede returns. For any sort of investment, fees matter. Alternative investments are often burdened with more than their fair share of costs we find difficult to justify.

  • Management fees can range from 1–3% of committed capital.
  • Hedge fund managers’ incentive fees are traditionally 20% of your profits.
  • Other fees are often buried in the fine print. For example, a leveraged buyout fund may charge extra fees for a company buyout, deals that fall through, and arranging post-buyout asset divestitures.

Cash flow constraints related to capital calls. Some alternative investments may call for stakeholders to make additional deposits into their investment at a moment’s notice. You can end up in a tough predicament if you’ve signed up for that ride without sufficient liquidity on hand if needed.

Alignment with your investment portfolio. Among the best ways to build long-term wealth is to create a low-cost, globally diversified portfolio, and maintain its asset allocation through disciplined rebalancing. Especially if it lacks liquidity, an alternative investment won’t fit well with this core strategy for pursuing your essential retirement or wealth transfer goals.

Alternative Investing for the Wrong Reasons

Based on the factors just described, we typically do not recommend investing in highly illiquid alternative assets until your net worth exceeds $10 million, and the core of your portfolio is invested in low-cost, well-diversified, and (most importantly) relatively liquid vehicles.

If all of the above applies to you, there may be a place for alternative investments in your portfolio—if you’re making the right choices for the right reasons.

First, let’s cover what we consider to be the wrong reasons:

Popular appeal. People often hear of alternative investment opportunities at social functions, from fellow executives, friends, etc. When mingling with your peers, it becomes tempting to believe investing in alternative assets is a social “must.” Let your friends invest how they please, but this sentiment runs counter to the actual purpose of investing, which is to achieve your personal financial goals.

Exclusive access. The allure of exclusivity is often a strong draw as well. It becomes easy to assume you’re going to do well with no questions asked, just because it’s a private investment opportunity.

We caution against making any such assumptions. Even when an investment feels like an exciting “sure bet,” it deserves careful due diligence before it becomes part of your essential portfolio.

Alternative Investments: Risks and Expected Rewards

Many investors move toward alternative investments looking for two things: increased returns and increased diversification. Even when it might make sense to participate in an alternative investment to seek these opportunities, it’s essential to go in with your eyes wide open to the significant risks involved.

Specifically, while outperformance is possible, it’s by no means guaranteed. Outcomes among private equity, hedge fund, venture capital, and private real estate vary widely. Prices often swing wildly as well, even though scant reporting may mean you won’t see the volatility playing out in real time (as you would with a stock or mutual fund).

Also, the median return for private equity is much lower than its mean (average) return. In other words, like the lottery, there is a relatively small chance of a high return, but when there is one, the “payoff” can be huge. Are you prepared to stomach a large dose of risk for a small shot at earning oversized returns?

Alternative Investments for the Right Reasons

Despite everything we’ve described so far, there can benefits to investing in alternatives if you are able to handle the potential cash flow constraints, illiquidity, and performance risk. For example, assuming you have done your proper due diligence on a fund, private debt deals may provide enhanced income in low-yield environments based on the following sources of higher expected returns:

Liquidity premium. As described above, investors in this space have less flexibility to trade or redeem their investments, and no control on the timing or size of cash flows. In exchange for sacrificing on liquidity, they should expect to receive a liquidity premium.

Manager-specific alpha. In an index fund, you simply accept the risks and returns of the overall market in which you’re investing. In an alternative investment, your fund manager has the opportunity to either underperform or deliver premium returns (alpha) relative to their market. There are no guarantees or expectations either way, and evidence suggests long-term underperformance is more likely. That said, some fund managers may have years of specific experience and access to deals that others do not, due to reputation or skill set. In short, you may get lucky with a particular fund manager.

Potential diversification benefits. In theory, investments in specific early-stage companies, company buyouts, precious metals, digital currencies, artwork, etc. should have a lower correlation to publicly traded stocks and bonds, thus offering diversification benefits. But there’s one big caveat: Just because alternatives may not always move in lockstep with traditional investments, they still may not offer optimal diversification. Historically, these types of investments certainly can and have fallen when U.S. and international stock markets have been down as well. This means, just when you’re most depending on an alternative to offset traditional market risks, it may be most likely to let you down.

Next Steps

We hope we’ve now given you some talking points to consider if you have been presented with the opportunity to invest in an alternative investment. Again, if you are being pressured to make a snap decision, we would suggest you err on the side of caution and give it a pass … at least if it means investing any assets you depend on to sustain your essential lifestyle.

That said, you may still be interested in using some discretionary income to participate in high-risk, lottery-like ventures that offer a small possibility to earn huge returns. Could you use help deciding if a particular opportunity is a good fit for your financial situation? We can help. Click on the image below to schedule a quick 15-minute consultation with our Family Office team to learn how we help people make these decisions with confidence.

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This material has been prepared for informational purposes only and should not be used as investment, tax, legal or accounting advice. All investing involves risk. Past performance is no guarantee of future results. Diversification does not ensure a profit or guarantee against a loss. You should consult your own tax, legal and accounting advisors

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Originally from the Chicagoland area, Jacob joined Plancorp in 2017. Jacob’s passion for helping clients find the best financial solutions and the challenge of working through complicated financial situations makes him a natural fit for Plancorp. He says he was especially drawn to our firm because of our team-based culture and focus on employee development. More »