Beware of so-called ‘liquid’ alts for retail investors

Some are useful to a subset of investors with a long-term horizon; not to everyone.

In the independent broker-dealer and RIA space, the term “alternative investment” means exactly what it implies: It is an alternative to commonly held liquid investments traded on a public exchange. Alternatives can be inappropriate for those who cannot afford to lock up significant capital for a long period of time.

An ideal time horizon for such vehicles is measured in years, not weeks or months. And partly because of that, there are elevated risks, but also the potential for elevated returns – basic concepts re pulled straight from Investing 101. Financial advisers worth their salt understand this, along with many of the other pros and cons associated with recommending alternatives for a client’s portfolio.

(More: The best and worst liquid alternative funds over the past 10 years.)

Still, recently we have seen an influx of new alternative products including real estate-based interval funds, non-traded REITs, and business development companies – that may appear to promise liquidity. This trend ignores the principle that these vehicles are inherently illiquid.

Providing short-term liquidity except in extreme circumstances wipes away much of the underlying rationale for why they were created in the first place – to provide investors with a long-term holding that is both not correlated to equity markets and, depending on the investment, capable of generating income in a yield-starved environment.

The most important message for financial advisers and their clients is that the market can’t have it both ways. Unfortunately, the benefits of liquidity and having exposure to alternatives are largely mutually exclusive.

LIQUIDATION PROBLEMS

Providing investors with the ability to cash out on a quarterly, bi-annual, or even yearly basis may meet some technical definitions of liquidity, but it doesn’t offer the benefits traditionally associated with liquidity. Alternative investments are subject to unique market cycles, seasonal events, and a crush of project-specific variables that make such timelines arbitrary and meaningless.

Indeed, most have hefty upfront costs to acquire real estate or to provide capital to businesses that immediately result in a dramatic reduction in their cash holdings and possibly in short-term valuations. So even if clients were able to liquidate their investments before the advised holding period expired (which they shouldn’t do), that’s not liquidity, since they would probably not be able to recoup a significant portion of their principal.

Alternative funds may be required to set aside a percentage of their holdings to meet potential redemptions. But when these assets are also used to make income distributions, it further reduces investment capital levels and thus, possible returns. Ignoring for a moment that this is another reason why alternatives are incompatible with liquidity, it highlights the importance of knowing whether income distributions are the result of earnings or simply paid out of un-invested capital.

Put simply, income distributions that are paid out of un-invested capital potentially reduce – sometimes significantly – the long-term upside gains that retail investors could receive over the life cycle of the investment product.

KNOW THY INTERVAL

Though the practice of marketing interval funds as essentially another type of mutual fund is, thankfully, in decline, it hasn’t disappeared from the industry. Interval funds are made up of a collection of private assets and are not just another ’40 Act fund.

Unlike traditional mutual funds, interval funds have no marketplace or daily NAV. They also are not redeemable within eight days. The underlying structure of interval funds doesn’t mesh well with liquidity. Investments that comprise interval funds are typically long-term holdings that can serve a purpose for a limited number of investors with specialized needs, which is how they should be marketed. Advisers should beware any product company dressing up retail alts to appear to be something they are not.

(More: Creation of new interval funds outpacing that of nontraded REITs.)

Non-traded REITs, BDCs, interval funds and a host of other alternative products have a place on broker-dealer product shelves. When employed correctly, such products offer a select group of clients the added layer of diversity they need to meet their retirement and investment goals. At the same time, advisers should be skeptical of any vehicle attempting to meet too many needs at once, because one thing alternatives were never meant to do is offer liquidity.

Clive Slovin is president and CEO of The Strategic Financial Alliance.