The advisor’s essential role as alternative investments go mainstream

Doors are being opened, moats are being filled in … whatever your preferred metaphor, it is obvious we are in the middle of a transformative moment when it comes to investor access to alternative investments. 

In just the past few weeks, we’ve seen the House of Representatives vote in favor of significant updates to the Accredited Investor definition and the new Chair of the SEC make remarks that signal a clear openness for changes that could ease the path for “retail” investors to gain access to hedge funds, private equity, private credit and other historically “alternative” strategies. Even the staid 401k is now a clear target for alternative asset managers, eager to tap into the massive pools of capital that space represents. 

The case for alternative exposure has long revolved around its role as a diversifier, hedge and/or source of uncorrelated alpha, far different from what could be provided via typical public market or 40 Act fund exposure. At Verdence, we have long discussed the benefits of a well-constructed alts portfolio with clients for whom such exposures were the right fit for their goals and needs and made deep manager due diligence a cornerstone of our efforts. 

Investor education is crucial. Take liquidity as just one example… private market vehicles tend to be illiquid. While this is often viewed as a drawback, there are positive aspects. It prevents investors from acting irrationally during bear markets. A “panic sale” simply is not allowed. Additionally, knowing there will not be panic-driven outflows allows managers of these investments to act in a rational long-term manner, an important driver of long-term performance.

But investors must understand this illiquidity and must not overcommit their resources. In terrible markets, liquid investments drop in value and often illiquid managers call capital to take advantage of the moment. If an investor is not adequately prepared for this moment, they will find themselves facing significant penalties as per their agreement or selling for pennies on the dollar in the secondary market. Rigorous planning and due diligence are even more important in such markets and this is one of the many reasons these investments have been restricted in the past.

The case for alts has been growing though and certainly has been strengthened by the fact that the number of public companies has dropped precipitously since Sarbanes Oxley. In the past, public markets presented a feasible path to wealth for many investors. If one could find a company with a great future, one could invest in that company through the purchase of its publicly traded stock.

Great companies like Microsoft, Apple, and Amazon built their enterprise values in the public markets. Today, however, companies are staying private longer as capital formation has shifted and as the pressures on many companies to IPO as the next logical step in their growth trajectory have waned. 

But what may make sense for these companies can end up being severely detrimental to average investors, who now too often find themselves blocked from accessing so many of the most exciting growth opportunities currently unfolding, so it makes sense that Congress and the regulators would be looking for ways to once again give investors the opportunity to invest in businesses in their rapid growth phase. Opening this type of access may indeed prove critical to many investors’ long-term risk-adjusted returns or, to put it more bluntly, mean the difference between achieving their goals and not.  

The potential risks, however, are many and it is incumbent upon our industry to act with a fiduciary’s mindset as we, and increasingly our clients, are being pitched on strategies, partnerships and fund structures that may not be all that the marketing documents would lead us to believe.

For example, traditionally, alternative investments have carried significantly higher fees and there is little doubt these fees will be exaggerated for new small investors. As most high-quality managers have high minimums, banks, brokerage firms and other product developers will move quickly to create vehicles to give small investors access by bundling their funds into “feeder funds.”  

While these feeder funds are advantageous from an access standpoint, investors will need to be very careful in understanding the total fees paid. Fees are often layered, not easily determined in the complex subscription documents and significantly lower returns. Investors must demand total transparency when dealing with anyone trying to sell them on investments of this kind and their advisors should always vet opportunities with their best interests at heart. 

After all, up until this point, certain doors were closed and certain moats in place for a reason. These are, in their very nature, sophisticated investment strategies that need to be understood not just through the lens of the exposure provided but with regard to an investor’s time horizon, liquidity needs, tolerance for risk and much more.

We should applaud efforts to level the playing field for so many investors who have found themselves on the outside looking in at today’s modern markets, but we should ready ourselves. The salesmen will be many, so the stewards will need to be prepared.

Leo Kelly is the founder and CEO of Verdence Capital Advisors, a private wealth advisory and multi-family office firm headquartered in Hunt Valley, Maryland.