6-Minute Read
The beauty of the investment world we live in today is the vast number of choices available. Some build portfolios with stocks, bonds, and cash. Others directly start their own businesses or focus on real estate. Many use a combination of all these so-called “traditional” investment methods. While I called it a beauty, it’s also a paradox of choice that can be overwhelming.
But it doesn’t end there. One topic that’s getting a lot more chatter this year is alternative investments, or alts.
Effectively, what I’m defining as “alts” here is the subset of investments that were previously restricted to a small group of accredited investors. But now many of these alts are more mainstream, available to individual investors. They include venture capital, private equity, private debt, hedge funds, derivatives, collectibles, crypto, etc.
The appeal, or at least the pitch coming from those who sell alts, is that they present an opportunity for higher returns than traditional investments or, at least, better risk-adjusted returns. The latter could be thought of as getting the same return as a competing investment, but with a smoother ride getting there. Sounds great, right?
Just a brief tap on the brakes might help. In recent months, I’ve had a handful of clients ask about alts and my thoughts on them. This is a complex topic to generalize, but I’d like to give it a shot and consolidate some insights. In this piece, I’ll provide brief answers to three critical questions you should ask before using alternative investments.
- How Big is your Due Diligence Burden?
- Will Alts Really Improve Your Diversification?
- What Issues Might You Face with Alts Once You’re In?
One – How Big is your Due Diligence Burden?
As an investment advisor, it’s tough for me to know sometimes when I’ve done enough due diligence on a potential investment for a client. Alts magnify that challenge.
Among other things, they require sophisticated analytical capabilities to assess a manager’s strategy, track record, operational controls, and the underlying assets. But let’s briefly look at four higher-level issues that make the due diligence so complex.
The challenge of selecting managers persists. Even if certain parts of private equity or venture capital appear attractive on average, identifying the managers that will outperform going forward is extremely difficult. This is a “game” we at KWP generally choose not to play even with public securities, as consistent outperformance is rare and often involves higher costs. However, a valid argument for alts is that if there are mistakes and inefficiencies out there, a skilled manager could identify and capitalize on them more effectively than a manager in the public securities space.
Alts have varying reporting standards. Unlike publicly traded funds, disclosures and performance reporting standards for alts can still leave a lot to be desired. This makes it challenging to get a clear, apples-to-apples picture of their true performance and underlying risks.
On a related note, there’s limited regulatory oversight, at least when compared to investments in the public markets. Alts, especially private funds, are generally less regulated by bodies like the SEC (Securities and Exchange Commission) than public mutual funds or ETFs. This means fewer mandatory disclosures, less standardization in reporting, and potentially less investor protection compared to highly regulated public market products.
There can also be a lack of transparency. Even beyond formal reporting standards, the underlying holdings and specific strategies of private funds can be opaque. Investors often have limited visibility into the specific companies, properties, or loans the fund is invested in, making it harder to understand the true risk profile or the factors that will impact their long-term investment experience.
Be prepared for access restrictions. This might be less of an issue today than in the past. However, even if you’re an accredited investor, it can still be challenging to access top-tier alternative funds (assuming you can even identify those in advance). Such funds often have very high minimum investments and are oversubscribed, mainly available to large institutional investors. Individual investors might only have access to newer, smaller, less established funds, or more expensive “feeder funds” that combine various alternatives.
Presumably, as an investor in alts, you’re aiming to achieve an excess return over some type of traditional portfolio. Even if such an excess return was available from alts in the past, much of that advantage may have already disappeared.
Two – Will Alts Really Improve Your Diversification?
Proponents of alts argue that they provide better diversification. This is based on portfolio theory, which suggests that adding more investments with different statistical correlations can improve your risk/return tradeoff. Bear with me on this.
A key reason alt investments have different correlations is that they are structured differently from traditional stock and bond portfolios. For example, private equity might experience a J-Curve effect or simply follow a different path to profitability. I will not directly argue against points like these with the math nerds, but I’ll highlight two important caveats.
Historical correlation benefits might be overstated. Unlike publicly traded stocks or bonds, which have daily market prices, alternative investments are often valued less frequently (e.g., quarterly or annually) and depend on models, appraisals, or recent transactions. This introduces some subjectivity.
Valuations can be “stale” (not reflecting real-time market changes), may be less transparent, and can be influenced by the fund manager, making it challenging for investors to determine the current market value of their investment accurately. This can smooth out reported returns (making them seem less volatile) but might conceal the true underlying risk.
You are likely to care more about behavior during severe market downturns. In a “flight to safety” or widespread economic crisis, even supposedly uncorrelated alternative assets can decline in value, potentially failing to provide the expected diversification when it’s needed most. Add back in the liquidity risk (see next section), and it becomes very reasonable to question if there are any net benefits to diversifying with alts.
Three – What Issues Might You Face with Alts Once You’re In?
Finally, we’ll examine what life is like after you own an alt. There might be more problems than these, but let’s focus on four of them.
Alts can have higher and less transparent fees. They often come with various fee structures that are significantly higher and sometimes less straightforward than those for traditional public market securities.
You might be familiar with a fee model where, for example, you pay a percentage of the asset size as your fee. With alts, these ongoing fees are likely to be significantly higher, and if they perform well, you could end up paying additional fees on growth above a certain threshold. This combination of fees can impact your net returns as an investor.
Alts may have significant illiquidity. One reason alts often claim higher expected returns is that they limit when and how you can access your money. In industry language, this is called a liquidity premium.
For those who talk to me about investments, they know I love discussing premiums. However, with some alts, there’s a real risk that you might not be able to access your money when you need or want to. For certain alt funds, complete withdrawal can be very difficult.
Not everyone has the same liquidity needs or time horizons for their investments, and these are important factors in deciding if alts are suitable for you. However, it might alter your perspective on an investment if you knew upfront that you could never fully exit from it. How would you feel about that during times of extreme market stress or personal emergencies?
Alts have the potential for “capital calls,” which is something to consider with some private real estate or private equity funds. It’s the risk that you’ll have to put in more money beyond your initial commitment to keep your equity stake, especially during tough economic times or refinancing at higher interest rates. I’ve had a few clients encounter this issue on the real estate side, and it can be a challenging situation to handle.
Alts may have tax complexity. Many alternative investments (especially those structured as partnerships or Master Limited Partnerships – MLPs) issue Schedule K-1s for tax reporting, rather than simpler 1099s.
K-1s can be complicated, arrive later in tax season (which can delay your tax preparation), and may include complex items like Unrelated Business Taxable Income (UBTI) for tax-exempt investors such as IRAs or foundations. This can lead to additional filing requirements and taxes. Just some things to consider if one of your goals is to simplify your financial life!
Parting Thoughts on Alts
Ok, alts are complex. We get that. But complexity can be worthwhile if it helps you better reach your goals. Also, anything that’s different from the mainstream will face some resistance but might eventually be adopted (think index funds when they first appeared in the 1970s).
The alternative investment landscape is evolving. More funds are emerging that may effectively address some of the concerns I’ve mentioned. They may provide structures with greater transparency or more straightforward liquidity options.
The main question is whether alts will improve your chances of achieving your specific financial goals. Right now, I remain skeptical about giving a positive answer to that for most people. However, like with any investment venture, it’s important to do your homework and understand as many risks as possible before investing your hard-earned money.
If you have comments or questions on this piece, please drop me a line at: [email protected]
References
- https://www.sec.gov/resources-small-businesses/capital-raising-building-blocks/accredited-investors
- https://www.investopedia.com/terms/j/j-curve-effect.asp
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