Learn alternatives, but tread lightly

The world of alternative investing, already commonplace among pension funds, endowments and foundations, is opening up for individual investors as mutual fund companies and other financial firms develop suitable products.

At the same time, individual investors are reading and hearing more and more about alternative investments being used by institutions and the superrich, especially the many varieties of hedge funds and private investments, and the billions of dollars being earned by the most successful hedge fund managers.

So it’s not surprising that financial advisers are getting more questions from clients about alternatives, and surveys show that individual investors are more willing to consider alternatives in their portfolios. Many individual investors have learned that a portfolio consisting of developed-markets stocks, bonds and cash is not really diversified, so alternative investments suddenly are a hot topic.

As reported in the most recent issue of InvestmentNews, a survey by Natixis Global Asset Management SA found that 72% of the investors surveyed would consider alternative investments if their advisers recommended them, up from 35% in 2012 — and 85% said they would invest in alternatives if they understood them.

DON’T GET CARRIED AWAY

But advisers should not get carried away, and should temper their clients’ enthusiasm.

Alternative investments are defined as vehicles that have different risk and return profiles from developed-markets stocks, bonds and cash. They include emerging-markets mutual funds and exchange-traded funds, long/short mutual funds, real estate investment trusts and, for those with sufficient investible assets, hedge funds and even private-equity funds.

Alternative investments can enhance the risk/reward profile of many portfolios if employed appropriately, and financial advisers can expect more questions from clients about whether such investments should be in their portfolios.

Financial advisers must be prepared to educate their clients about what alternatives are available to them, how those alternatives work, what they can and cannot do for their portfolios, and what the realistic expectations are. They should emphasize that alternative investments are not a panacea but are enhancements to well-designed portfolios structured to achieve specific goals.

Remember, 85% of investors would use alternatives if they understood them, according to that Natixis survey.

The plethora of alternatives available to institutional investors is not available to the average individual investor in liquid form at present, and may never be. For example, hedge fund investment minimums are too high and the lockup periods are too long for the average investor, who generally likes fairly liquid investments. Likewise, private-equity and venture capital funds require initial commitments that are too large for the average investor, and lockup periods are too long.

WELL-PLANNED ADJUSTMENT

Therefore, the returns generated by the alternative vehicles available to average investors might disappoint them if they compared those returns with the reported returns of institutional alternative investments. Financial advisers must be prepared to explain that to clients.

Before recommending alternatives to clients, financial advisers first must decide what alternatives they are comfortable recommending to their clients and educate themselves about those vehicles.

Not that each adviser can become an expert on every alternative suitable for his or her clients. Rather, advisers and their firms must find where the appropriate expertise exists and make contact with the experts. The advisers must learn from those experts, then get out and kick the tires of the vehicles they believe might be suitable for their clients.

They also must review each client’s portfolio to see where alternatives might enhance the long-term returns, either by increasing returns or reducing volatility. One size will not fit all, so the alternatives portfolio will have to be tailored to each client’s investment horizon, risk tolerance and expected liquidity needs.

All of this will take time, but the move into alternatives by individual investors should not be rushed. It should be a slow, deliberate, well-planned adjustment to client portfolios guided by well-prepared advisers.

Rushing into alternatives only invites trouble.

Related Topics: Asset Allocation, Investment Strategies