It wasn’t too long ago that investments in commodities, real estate or hedge funds were considered somewhat exotic. But today, alternative asset classes are proving not-so-alien as private markets outperform public markets and Americans incorporate alternative investments into their retirement plans.
The popularity of PE,VC, real estate and other alternatives is a result of higher potential returns, a shrinking number of public companies and 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 June of 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 ERISA. 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 opens retail investors up to alternative investment funds, private equity is a complex investment, 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 types of investments.
According to one paper, “Alternatives in the Mainstream,” based on a 2017 survey by InvestmentNews and developed with Blackstone, “Traditionally ‘alternatives’ meant assets and asset classes that had negative or very low correlations to the traditional asset classes of equities, fixed-income securities and cash. In simple terms, when traditional stocks and bonds zigged, alternatives were understood to zag.”
However, because of some of the shared impact of public trading on both the traditional and alternative marketplaces, the line may be getting fuzzier.
For example, the paper continued, “If an office building is part of a real estate investment trust whose shares are traded publicly does that make it an alternative—or more similar to a traditional equity investment?”
Regardless, the private market continues to steal the show. A 2020 McKinsey report found that private market assets under management (AUM) increased by 170% or $4 trillion in the last decade—and 10% in 2019 alone. Meanwhile, global public market AUM has grown by 100%, with the number of publicly traded companies down 40% since 2000.
According to the US Census, 10,000 baby boomers enter retirement age each day, with all boomers reaching 65 by 2030. 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.
“For the retirement-minded, alternative opportunities can be accessed through individual retirement accounts such as self-directed IRAs,” said Jeffrey Kelley, senior vice president of Equity Institutional. “The power of a self-directed IRA comes from its broad access to investment options like private equity, real estate, precious metals or other alternatives to traditional investment choices.”
People are living 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 a challenge for financial advisors. Allocating more toward mainstream alternative investments assets is one proactive risk-management strategy used in today’s low-yield environment.
Despite projections on the popularity of alternatives, the SEC reports that individual investors allocate less than 5% of their assets to alternatives on average (compared to much higher numbers for endowments and pensions) despite global individual investable assets projected at $106 trillion by 2025.
The aforementioned InvestmentNews survey also highlighted some surprising disconnects between investors and advisors on alternative investments:
According to Kelley, “Alternative assets, such as real estate investment trusts, mortgage notes, limited partnerships, limited liability corporations, precious metals, joint ventures, actively managed funds and private equity are typically tax-inefficient and are taxed at short-term capital gains or ordinary income-tax rates.”
“Through a self-directed IRA program, investors can access the potential benefits of alternatives on a tax-advantaged basis”
Moving these assets into tax-exempt vehicles, such as IRAs and other qualified retirement plans, can increase net income without adding risk to the portfolio, InvestmentNews reported. Through a self-directed IRA program, investors can access the potential benefits of alternatives on a tax-advantaged basis, Kelley said.
“Self-directed IRAs invested in alternatives may provide a way for investors to diversify a portfolio beyond traditional equity, bond and mutual fund choices,” said Paul D. McConville, president of Quincy Capital Partners, LLC, which serves alternative investment managers. “In effect, with a self-directed IRA, investors may gain a wider scope of action for how, when and where to invest their retirement assets.”
A 2019 report backed by the Global Financial Literacy Excellence Center (GFLEC) and the FINRA Investor Education Foundation states:
“Data from the 2018 National Financial Capability Study (NFCS) show that only 30% of the general population demonstrates understanding of basic financial concepts such as the workings of interest rates, inflation, and risk diversification…”
The report warns that lack of investing knowledge and overall financial literacy can lead to poor diversification, paying higher fees, etc. They state,“Investors enrolled in dedicated contribution plans lack basic financial knowledge, so as the expansion of, and consumer reliance on, DC plans continues, the need for financial education is increasing, as is the need for regulation and investor protection.”
“Alternatives in the Mainstream” identified three areas where advisors primarily need support to increase their diversification to alternative asset classes:
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.
Says Kelley, “Managing payments, documentation and reporting can become more complicated in the world of alternatives. Qualified custodians in this area require an understanding of complex transactions and tracking capabilities for both contributions and distributions.”
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 can in turn 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. They would be wise to emphasize the value of alternatives as a diversification tool and an option for retirement portfolios.
[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Basic Investment Principles 101 – From Asset Allocations to Zero Coupon Bonds and What is a “Private Fund?”. This is an updated version of an article originally published on November 6, 2017.]
©All Rights Reserved. August, 2020. DailyDACTM, LLC d/b/a/ Financial PoiseTM
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