With the stock market volatility that characterized 2018 expected to continue this year, interest in alternative investments is rising.
More than half of advisors expect to grow their allocations in alternative investments by 25 percent over the next five years, and 13 percent plan to increase them by 75 percent, according to a national poll by Rydex Advisor Benchmarketing. With the potential for attractive performance attributes and increasingly attractive and flexible structures, a quarter of advisors even predict that these alternatives will become more important than traditional investments like stocks and bonds in the long-term, Rydex reports.
In the past, many independent Registered Investment Advisors (RIAs) have hesitated to choose alternative investments because investing in them was a cumbersome, labor-intensive process that led to a mountain of paperwork and increased compliance risk. But as new technologies streamline the process, RIAs with diversification goals are taking a closer look.
Setting the right expectations for investors is key for RIAs exploring alternative investments. Here are four alternative investment options advisors don’t want to overlook:
- Rethink REITs. Lack of product development and uncertainty surrounding the Department of Labor’s conflict of interest rule caused real estate investment trusts (REITs) to suffer slow growth in recent years. But sustained economic growth moving into 2019 is causing many advisors to re-examine the diversifying benefits REITs offer an investment portfolio, as well as their income-adding ability.REITs give ordinary investors the opportunity to own unique properties that, over the long-term, tend to perform well. Advisors should look for REITs that have buffers against rising rates, which can hurt their performance in the short-term. For instance, REITs that include tenants with mature business models tend to be more stable because they are likely to stay occupied longer. Industrial and single-tenant office REITs are currently in high demand.In exchange for the company distributing 90 percent or more of its profits as a dividend to shareholders, REITs are typically organized so there is no tax at the corporate level. Dividends from REITs are not qualified, so it’s wise to hold them in tax-advantaged accounts.
- Diversify through private equity. Once the mainstay of institutional and qualified investors, private equity is entering the mainstream. Greater transparency and access in private equity vehicles is prompting more RIAs to consider allocating funds toward private equity.Private equity investments can help RIAs meet diversification goals by offering access to opportunities that mainstream investments cannot. Not only do they offer the potential for lucrative returns, but because they don’t correlate to liquid market assets, they can be used to mitigate certain types of risk for certain types of investors.Even so, advisors need to understand what they are diversifying against before taking the plunge, whether that is other types of investments, beating cash returns, or a hedging against the overall inflation rate. Careful due diligence is critical to helping RIAs understand what’s on the menu of funds they’re considering and whether the investment is the best fit for their clients.
- Manage expectations of hedge funds. Once reserved for investors who could afford the multi-million-dollar minimums, many hedge funds are now offering products that cater to investors with mass-affluent, accredited clients.Hedge funds are renowned for employing a wide array of trades and strategies that take advantage of shifts in economic and geopolitical landscapes. Despite the industry’s mediocre returns in 2018, most investors are optimistic that hedge funds will offer positive returns in the long-term, data firm Preqin reports. In fact, two-thirds of institutional investors said they were happy with their hedge fund returns over the past year, according to Preqin.Recently, rising interest rates and high market volatility have caused many hedge fund firms to take on more of a consultative capacity when working with advisors. This makes it easier for RIAs to educate ordinary investors about the pros and cons of the structure and liquidity aspects of each fund. By doing so, they can discover the right balance of risk and reward for each client’s portfolio based on critical factors like objective, expectations, risk tolerance, and suitability.
- Be direct. With the potential for risk-adjusted returns and greater control over investments, many RIAs are sharpening their focus on direct investing. These direct deals often materialize as private investments in small and mid-size privately-held businesses, venture firms, real estate, entertainment and media, and more.Direct investing enables RIAs to retain nearly complete control through the investment process. It also provides more flexibility when negotiating terms with the underlying company, which often results in lower fees and better investment terms. It can also fulfill an increasing demand among new generations of investors interested in environmental, social, governance (ESG) and socially responsible investing (SRI).Direct investments can offer strong returns with less inflation risk and lower correlation to equity and credit markets. They can also offer an attractive alternative to the high fees and lack of control experienced by investing in private equity funds.
As private markets expand and public markets remain volatile, stuffing portfolios with publicly traded securities and vehicles alone is an increasingly outdated investment approach. Progressive advisors are serving their clients by exploring alternative investments that combine desirable performance characteristics with diversification benefits unavailable in traditional public markets.