It’s time to educate your clients, and yourself, about alternative investments

Individual investors are being tempted by alternative investments as they seek greater diversification of their portfolios, so advisers should be preparing to answer questions about them from their clients.

Alternative investments generally are any investments that are not publicly traded such as stocks, bonds or cash equivalents. They include hedge funds, private equity (typically venture capital and leveraged buyouts), private loans, direct real estate investments, commodities, currencies and even precious metals. Some include options trading, which can be used for hedging or generating additional income.

As individual investors have become more knowledgeable about investing, often thanks to the efforts of investment advisers, some have begun to consider investments that are atypical. Often, these investors are seeking to diversify to generate a higher return for a given risk level or to earn an acceptable return at a lower risk — the Harry Markowitz definition of efficient portfolios.

Most alts once required financial commitments beyond the reach of all but the wealthy, but some are now being packaged in smaller slices that are within the reach of investors of more modest means.

(More: More advisers use alts, but few understand them)

So investment advisers must be ready to educate clients about alts, even though most will likely decide not to invest in them.

Pension funds have been using alts for 40 years, but before they began investing in them, they sought the advice of investment management consultants. The consulting firms knew they had to be ahead of their clients in learning about alternatives so they would be prepared to answer their questions. They knew that “I don’t know” was not an acceptable answer to pension plan executives who were paying for their advice.

So it is with investment advisers. Advisers must do their due diligence so they will understand the benefits and pitfalls of the most common alternatives.

With hedge funds, for example, advisers must know which strategies the available hedge funds use, how much risk each takes and how they could fit into each client’s portfolio. Which funds provide true diversification? Which are truly hedged, and which seek better-than-market returns?

Advisers must know about venture capital and leveraged buyout pools that might be open to clients with modest investible assets. They must research these pools to ensure they are suitable for their clients. They must know, too, which clients can accept the trade-off of less liquidity for possible high return. Both venture capital and leveraged buyout investments lock up an investor’s capital for up to 10 years before the return is earned. The reward is the potentially higher-than-market and noncorrelated return.

As stock market returns level off from the heady pace of the past few years, more clients will consider income-producing investments such as private loans or nontraded real estate investments. Advisers must be familiar with the risks for these investments so they can explain them and make the argument as to why they do or do not fit the client’s needs.

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Individual investors are constantly being targeted by advertisements urging them to invest in precious metals. Advisers must be prepared to argue the pros and cons. Yes, precious metals generally are a hedge against inflation, they have relatively low correlations with stocks and their value increases in times of political or economic uncertainty. But they often have high upfront costs and safekeeping costs, and they provide no income.

Like the consultants who advised the large pension funds, and still do, investment advisers must do their homework so they can be ahead of their clients. The trend toward using alternative investments in individual investors’ portfolios may be just beginning, but it will likely continue and grow. This is an area where advisers can demonstrate their value by guiding clients who are interested in such investments so they have success and avoid losses.