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Advisors turn to alternative investments for clients

  • New alternative investment vehicles and new platforms have become available to the high-net-worth retail sector in the past decade.
  • Morningstar identifies three types of "alts": nontraditional asset classes, nontraditional strategies and illiquid assets.
  • Some data show more diverse portfolios have performed better over the past 25 years than less diverse ones, but most advisors are still hesitant to add alts to client holdings.

crossroads alternative investments
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A combination of historically low interest rates, an exceptionally long bull market and memories of the 2008 crash have encouraged some financial advisors to add alternative investments to their clients' portfolios. The alternative investment industry has also made it easier by creating more and more products for retail investors over the past few years.

"Traditionally, investors would shift money from equities to bonds to reduce risk, [but] this time is different," said Sterling Neblett, certified financial planner and founding partner of Centurion Wealth Management. "Due to historical low interest rates and the high probability that rates will continue to rise, one may argue that shifting from equities to bonds may even increase your portfolio risk."

Accordingly, Neblett has been shifting equity exposure to alternatives strategies, such as option writing, long/short and private debt. These strategies tend to be less correlated with U.S. stocks, he said, and some — such as option writing — tend to be ideal in a volatile flat market. All his clients have from 5 percent to 20 percent of their portfolios in alternative strategies. He has accelerated this shift especially in the last six months, as U.S. stocks have been getting more expensive.

Over the past decade, new alternative vehicles and new platforms have become available to the high-net-worth retail sector, Neblett said, including feeder funds that aggregate smaller investors, money funds with alternative strategies and non-traded interval funds, which make periodic repurchase offers to their shareholders.

"There has been a shift in focus in the alternatives industry over the last 10 years," said Hans-Christian Winkler, certified financial planner with Claraphi. This shift has been from individual accredited investors, who could dictate investment terms, according to Winkler, to high-net-worth retail investors, who can be forced to lock up their money in certain alternative products for up to seven years.

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Winkler started incorporating alternative investments into his clients' portfolios about four years ago as more products came to market. These allow his clients to be less dependent on good stock- and bond-market performance and to potentially have better downside protection during market downturns, he said.

The alternative investments he employs originate from real estate investment/development companies (investing in triple net leases, apartment buildings, parking lots, senior housing, warehouses, lodging, etc.), finance companies, hedge funds, commodity managers, energy companies and futures managers.

"Alternative investments can either be equity replacements by having the ability to share in the profits, or bond replacements by receiving a steady distribution and return of principal at the end of the term," Winkler said.

Using real estate industry investment vehicles as examples, he said an equity replacement could be a development company paying a distribution (similar to a dividend) and sharing profits with investors at project completion. A bond replacement could be a loan company that provides short-term loans to other developers and pays a distribution (i.e., a portion of the loan payments) and nothing else.

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Some firms are embracing alternative strategies in a significant way.

Norman Boone, CFP and president of Mosaic Financial Partners, said his firm allocates 30 percent of every portfolio to global real estate investment trusts and liquid alternatives (generally, mutual funds and ETFs that employ alternative investment strategies).

The identity and the mix of alternatives changes, depending on the aggressiveness of the portfolio, he said. The firm makes it a priority to use only daily liquid alts.

"Largely, as a passive shop, we are using managers that apply a rules-based approach to choosing what goes into their funds," Boone said. The firm includes the following strategies in one or more of their models: global REITs, energy infrastructure, merger arbitrage, managed futures, timber REITs, business development corporations, equity market neutral and emerging market debt.

What are alternative investments?

According to research firm Morningstar, alternative investments fall into three camps:
Nontraditional asset classes, such as currencies and commodities.
Nontraditional strategies, such as shorting and hedging (in both traditional and nontraditional asset classes).
Illiquid assets, such as private equity or private debt.

The overall concept of alternative investment is more widely accepted and more in demand nowadays, he said. One reason is defensiveness, as clients were so hurt in 2008. Another reason is historical data, which has shown that more diverse portfolios have performed better over the past 25 years than less diverse ones.

Boone advises caution. "We advisors, as a group, need to evaluate how closely liquid alts come to what hedge funds returned in the past," he said. "You need to go under the covers — most of the liquid alt managers were hedge fund managers and just because a strategy worked as a hedge fund doesn't mean it will work in a new format."

The move toward alternative investments for retail investors, however, may not be widespread. While a 2014 report by McKinsey & Company predicted that "retail alternatives will be one of the most significant drivers of U.S. retail asset management growth over the next five years, accounting for up to 50 percent of net new retail revenues," a 2017 Financial Planning Association study found that only 8 percent of advisors were considering adding alternatives into client portfolios in the future.

— By Deborah Nason, special to CNBC.com

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