Beyond the Fringe: Alternative Asset Classes Go Mainstream

Defy Tradition with Alternative Investments

Not too long ago, investments in commodities, real estate, or hedge funds were considered somewhat “exotic.” But today, alternative asset classes are not so alien, and Hamilton Lane notes that private markets have been outperforming public markets for nearly two decades. Nasdaq forecasts total alternative investments to reach $17.2 trillion by 2025 as more Americans incorporate them into their retirement plans and portfolios.

Why Alternatives Are So Popular

The popularity of private equity (PE), venture capital (VC), real estate, and other alternatives is due to higher potential returns, a shrinking number of public companies, fewer IPO exits, and the need to diversify one’s portfolio with non-correlating assets. However, retail investors have historically been shut out of many alternative investment funds.

In a 2021 article, Allison Herren Lee of the U.S Securities and Exchanges Commission stated, “Congress and the Commission have steadily relaxed restrictions around private markets in a manner that has spurred their dramatic growth.”

Recent Developments and Increased Access

In June 2020, the Department of Labor (DOL) released an information letter stating that defined contribution plans (i.e., 401(k) plans) can include PE investment options and maintain compliance with the Employee Retirement Income Security Act (ERISA). In 2020, the SEC updated the accredited investor definition, expanding opportunities to retail investors.

Defined benefit plans (i.e., pensions) have long had access to these investments, but 401(k) plans have avoided them due to legal fears. While this development opens up retail investors to alternative investment funds, private equity is complex, and returns often depend on access to high-quality fund managers. Those who allocate more funds to the private market must be well-educated in these investments.

What Are Alternatives?

According to the CFA Institute, “alternative investment” refers to “a disparate group of investments that are distinguished from long-only, publicly traded investments in stocks, bonds, and cash.” The CFA Institute also points out that alternative investments aren’t necessarily uncommon or “new.” They can include real estate, commodities, and non-traditional approaches to private equity funds and hedge funds. The term “alternative investments” is very broad, and the types of investments vary.

According to Harvard Business School, the main difference is that traditional investments are bought, sold, and traded on a public market, while alternatives are not. Another difference is that alternatives are illiquid and cannot be easily converted into cash.

Regardless, the private market continues to steal the show. The 2023 McKinsey Global Private Markets Review reported private market assets under management (AUM) totaling $11.7 trillion in 2022, with an annual growth rate of 20% since 2017.

Alternative Investing as a Retirement Income Strategy

According to the U.S. Census, 10,000 baby boomers enter retirement age each day, with all boomers reaching 65 by 2030. A post-pandemic U.S. Census article reported those numbers skewing only “modestly.” The implications of economic policies on their retirement security are especially time-sensitive; few 65-year-olds will have time on their side to recover from a loss if their assets are hit by another event like the Great Recession of 2007-2009.

A self-directed Individual Retirement Account (IRA) allows retirement planners to invest in alternatives. According to the Financial Industry Regulatory Authority (FINRA), alternative investments, including real estate, precious metals, commodities, private placement securities, and promissory notes, are accessible through self-directed IRAs. However, the SEC and FINRA also warn about the potential for fraud with self-directed IRAs due to the lack of legal and regulatory protections.

People live longer, health care expenses are mile-high, and many boomers have little saved for their golden years. Generating enough income for clients during retirement is increasingly challenging for financial advisors. One proactive risk-management strategy used in today’s low-yield environment is allocating more toward mainstream alternative investment assets.

People Want to Know More About Mainstream Alternative Assets

Despite projections on the popularity of alternatives, the Alternative Investment Management Association reported that, in 2022, individual investors allocate only 2%-10% of their capital to alternatives. However, according to J.P. Morgan Private Bank, higher net-worth individuals may allocate between 15%-30%.

Typically, individuals allocate higher numbers to endowments and pensions. In 2020, global individual investable assets were reported at $510 trillion by McKinsey & Company. That same year, individuals invested about 2.6% of that in alternatives but nearly 7% in pension funds.

Still, according to BlackRock, the demand for diversification, growing even more with recent inflation, is helping to drive individuals’ interest in alternative investments. A 2023 Forbes survey revealed that 84% of individuals across all age groups expressed interest in alternative assets.

Investors and advisors must get on the same page regarding alternative investments, which often means better education for both parties. Investors need to learn more about the asset class, its risks, and opportunities, while advisors need to educate themselves to give the best advice.

Educating Mainstream Investors about Alternatives

According to the 2022 TIAA Institute-GFLEC Personal Finance Index, 50% of U.S. adults are financially illiterate.

The report warns that a lack of investing knowledge and overall financial literacy can lead to trouble making ends meet, debt constraint, poor diversification, higher fees, stress, and overall lower financial well-being. Comprehending risk was Americans’ most problematic area, with only 36% of respondents demonstrating understanding.

Many experts agree that inexperienced investors need more advisor support, financial education, regulation, and investor protection as interest in alternatives increases.

Wealth advisors can benefit from education, as well. The Corporate Finance Institute offers a course in which advisors learn about alternatives and how to educate clients about integrating alternatives into their retail investment portfolio. The Chartered Alternative Investment Analyst Association (CAIA) offers a certificate program, “The Fundamentals of Alternative Investments.” These are just two examples of the opportunities available to advisors who want to develop their competencies to further client understanding.

More Alternative Allocations Call for a Specialized Custodian

With alternative asset classes like real estate, precious metals, private equity, private debt, and investment crowdfunding opportunities on the rise, broker-dealers are realizing the importance of more specialized custodians.

Paperwork, payments, and reporting in such a diverse asset class require a qualified and capable manager who can handle complex transactions, safeguard assets, and prevent fraud.

Advisors are Advised to Study Up on Alternative Asset Classes

Mainstream alternative investments are no longer a contradiction in terms. In fact, these studies indicate that financial advisors at firms of all sizes are likely to increase their investment in alternatives significantly over the next three years.

Advisors are eager to broaden their knowledge of alternatives to assist clients. Accordingly, advisors who develop a specialty in alternatives can give better advice to investors. This, in turn, can build stronger, more valuable relationships with clients over the long term.

Advisors who want to gain an edge will know to go beyond simply recommending products. It would be wise to emphasize the value of alternatives as a diversification tool and an option for retirement portfolios.

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[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can view at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

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3. Tech Talk: Current Opportunities for Investing

This is an updated version of an article originally published on November 6, 2017, and previously updated on August 25, 2020.]

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