Alternative investments can open the door to an optimized portfolio. Are they right for you?
Alternative investments have become a bit of a buzzword in the investment industry, a hook for investors looking to stave off risks with some so-called out-of-the-box thinking.
But according to Bryan Mullin, head of alternative investments at RBC Wealth Management–U.S., alternative investments aren’t really that out-of-the-box when it comes to their basic details.
“Alternatives are just stocks and bonds put together with different legal wrappers and with a more active strategy,” says Mullin.
The investments still provide exposure to the three base asset classes—equities, fixed income and real assets (things like commodities, real estate, and infrastructure)—the same type of things you most likely already hold in your investment portfolio. But it’s the structures and strategies used that really define the alternative investments category, explains Mullin.
“This is where Wall Street has crossed with innovation,” he says.
And it’s that innovation element that has a tendency to lead to miseducation and confusion around alternative investments.
According to data from The Economist Intelligence Unit (EIU), commissioned by RBC Wealth Management, 72 percent of respondents in the U.S. agree that today’s global markets require investors to be far more flexible and responsive in their investment strategies.
The New wealth rising survey, which target both high-net-worth individuals (HNWIs) and their children, along with high-earning professionals, across the U.S., Canada, UK, Hong Kong, Singapore and Taiwan, also found 60 percent of investors in the U.S. expect a financial advisor to offer unique investing opportunities.
Alternative investments are an ever-evolving category with new strategies cropping up to reap the benefit of inefficiencies in the market. But from a top-down level, the investments can be broken down into those three principal categories: equity, fixed income and real assets.
Rather than contributing and taking distributions from a mutual fund, alternatives are often labeled hedge funds or private equity funds—both pools of accredited investors but each with their own quirks.
“Hedge funds tend to offer you at least some liquidity; they’re not liquid on a daily basis, but you can decide when you want to ask for your money back,” says Leif Gunderson, product manager for alternative investments at RBC Wealth Management–U.S.
Hedge funds tend to invest in listed securities, Gunderson explains—things you could go and buy on the stock market. “There’s just a different risk-return profile to hedge funds,” he adds.
Hedge funds, says Gunderson, are looking to benefit from inefficiencies in the actively traded markets. For example, maybe a particular hedge fund has identified a niche type of bond structure they can buy cheap and hold until it’s worth more. Or maybe they’re making short plays where they’re selling a security in anticipation of a drop in price and planning to buy it back at a lower price.
Private equity, on the other hand, plays by its own set of rules.
“On the private capital side, the key delineation is you can’t ask for your money back,” Gunderson says. “You make a commitment to a fund and they will invest it over time as they find opportunities.”
In these cases, investments tend to not be listed on the market. Private equity funds may, for instance, invest in a real asset like a building or a private business like a new startup or offer private debt lending.
“There’s a variety of higher risk-return or lower risk-return strategies in private markets where it’s completely illiquid and you don’t get your money back until the fund manager sells that building or that company,” Gunderson says. “Then, hopefully, they send you back a lot more money than you sent them in the first place.”
Because of the recent piqued interest in alternatives, there’s been a push to make the category more accessible to the everyday investor. But from Mullin’s perspective, it’s not a category for everybody.
But for the right type of investor, alternatives can open the door to a more optimized portfolio and some creative ways to build value from your investments.
Commodities and real estate holdings (24 and 31 percent) are most popular with investors in the U.S. who have more than $5MM in personal wealth, followed by hedge funds (26 percent), according to the EIU data.
The most important question for an investor considering adding alternatives to their portfolio, Gunderson says, should be, ‘What is the goal?’
“The answer shouldn’t be, ‘My neighbor was telling me about this sweet new idea he had, so I want to do it,’” he says. “That’s exactly why we don’t want to do alts.”
In general, alternatives tend to be less liquid and involve more complex strategies. They’re also often engaged through non-registered security offerings of partnership structures—the type that requires a bit more paperwork for the investor. For that reason, Gunderson points out that alternative investments are usually a more effective strategy for investors with qualified purchaser status (in other words, someone with more than $5MM net worth).
“That qualified purchaser criteria (allows you) to get in the broadest array of these private alternatives,” Gunderson says.
As with any investments, your time horizon and the appetite for risk afforded by that horizon also matters. That’s why alternatives are a more efficient strategy when you’re OK with illiquidity and comfortable holding money in investments for 10 years or longer.
The New wealth rising survey found 29 percent of those surveyed in the Silent Generation across all regions say liquidity is a factor when considering investing in alternatives, compared to 19 percent of Gen Z or millennial respondents.
“If they have a lot of liquidity needs, maybe they’re just coming up on retirement, they have two kids just going into college, they haven’t yet paid off their house but they want to be able to buy a vacation property—(that’s not) the client you’re going to say ‘OK, I’m going to take 20 percent or a million dollars of your portfolio and lock it up,’” Mullin says.
But if you’re retired, your kids are self-sufficient, you own two homes outright with $10MM in the bank and $10MM in your portfolio, it might make sense to put some of your investments to work in the alternatives sphere. With that level of investable assets, says Mullin, you can start looking for ways to “optimize the portfolio better and squeeze a little bit more value out of things … it’s worth the time and effort.”
Gunderson says employing a longer-term strategy like private capital investments for your portfolio means you need to have a solid plan in place, one that accounts for how much you’ll want to invest per year and how that fits within your overall investment goals.
“There are a lot of moving parts, and you want to think of your whole portfolio—when the money’s expected to go in and come out, and really how much you want to have invested over time,” he says.
Any plan, Gunderson adds, is a living plan.
Investment and insurance products offered through RBC Wealth Management are not insured by the FDIC or any other federal government agency, are not deposits or other obligations of, or guaranteed by, a bank or any bank affiliate, and are subject to investment risks, including possible loss of the principal amount invested.
RBC Wealth Management, a division of RBC Capital Markets, LLC, Member NYSE/FINRA/SIPC.
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