From the August 2007 issue of Boomer Market Advisor • Subscribe!

August 1, 2007

Drop preconceived notions, consider alternatives

After many years of recruiting and managing independent financial advisors, I've observed a wide variety of investment styles and philosophies. Some advisors believe their own research and market perspective will enhance client returns above their competitors. Still others believe client needs can be met with the proper use of life insurance, the best combination of ETFs and the right choice of variable annuity sub-accounts. Some are so focused on their individual specialties that they overlook new ideas. I should know. I was one.

I began my career nearly thirty years ago as a registered representative with a large Midwestern firm. In the 1980s, with the Dow still under 1,000 and interest rates hitting record highs, few investors were attracted to long term equity investments. High marginal tax rates created investor interest in anything that provided tax write-offs or tax-sheltered income. This was my specialty.

However, tax reform legislation that followed caused many of the investments to fail. That experience, along with the bull market that followed, lead me to conclude that energy investments should be left to energy giants, commercial real-estate investments are better suited for institutions and any investment structured as a limited partnership was too risky. I was convinced that my clients' objectives could be met with the right combination of mutual funds. But after years of living in Texas, where seemingly everyone has an oil lease investment, I reconsidered the value and risk of so-called alternative investments.

While I was busy tinkering with my mutual fund allocations, I watched many colleagues achieve far greater returns by adding real estate, oil and gas and other alternatives to client portfolios. While I couldn't get beyond the phrase "limited partnership" on an investor memorandum, associates were receiving substantial first year tax write-offs and a complete return of invested capital within a few years.

Individual investors enjoyed steady distributions and solid overall returns by investing in high quality office and apartment buildings through non-traded REITS. In the past 20 years, foreign investors benefitted from deals in the suburban U.S. They did so by using the same limited partnerships I once considered too risky. Thousands of individual investors achieved real estate diversification, tax savings and increasing income through the use of 1031 exchanges in tenants-in-common. While such returns might not be seen again, I missed out because I never considered alternatives.

Even expertise in alternative investments can become an overused specialty. Some advisors are so successful with 1031 exchanges that they completely overlook the rest of the investment portfolio. Rising prices and shrinking cap rates in commercial real estate should cause some to carefully consider the timeliness of a 1031 exchange. However, even alternatives to 1031s are now available. Some real estate investors, anxious to sell highly appreciated holdings (yet feeling constrained by the tax consequences) are using a relatively new structured sale strategy to manage distributions and taxes on capital gains. This allows a seller to enjoy the benefits of a cash sale but receive the proceeds on a schedule that the seller stipulates. Distributions and taxes can be deferred over a number of years with payments guaranteed by large, highly rated insurance companies.

It's a challenge for any advisor to keep up with on-going development of complex investments solutions, something that requires education in new approaches and alliances with other professionals. At the same time, many broker/dealers do not support alternative investment strategies because they lack the interest or resources to properly assess the risks and merits. Firms must make an effort to support innovation with careful evaluation, comprehensive education and thorough due-diligence for each new investment alternative.

Today's successful advisor won't simply rely on products and strategies that have worked in the past. They must identify what's of value in the portfolio, as well as what may be missing. Safety through diversification applies not only to your clients, but to your investment practice as well. Be sure you consider all of the appropriate alternatives.

Reprints Discuss this story
This is where the comments go.