When it comes to alternative assets, investors and their advisors need to proceed with caution. AdvisorOne’s recent piece, “Top 10 Dangers of Alternative Investments,” was a good reminder of what might go wrong.
The experience of 57,000 PENSCO clients and their financial advisors suggests that much can also go right. As a custodian of alternative investments in retirement accounts, PENSCO has seen a rapid growth in alternatives over the past few years as investors and advisors seek to enhance return, lower risk, realize tax benefits, broaden investment options and improve client satisfaction. In that spirit, here are our top five reasons to invest in alternative assets:
1. Better Risk Management
Alternative assets offer investments that are not correlated to the returns of traditional, liquid investments. That typically leads to better return with less volatility. When a traditional portfolio of stocks, bonds and cash includes alternative assets, investors can realize a higher blended rate of return with lower volatility. Thus, when U.S. large-cap or small-cap equities are headed south, direct investments in an Argentinian fish farm, a multifamily housing complex or a global hedge fund may offer the diversification needed to mitigate a shock to the portfolio.
2. Enhanced Investment Performance
Alternative investments in direct investments and pooled funds remain among the top performers in the investment universe. After a decade of lost stock market performance, that’s critical. According to J.P. Morgan Asset Management, the expected annualized compound return over 10 to 15 years is 8.25% for U.S. private equity, 7% for (unlevered) direct real estate, 8% for global infrastructure funds and 7% for diversified hedge funds.
The projected return over the same period for such traditional assets as U.S. large-cap stocks is 7.75%, and 8.25% for both mid-cap and small-cap stocks. When both traditional and alternative investments are part of an allocation plan, a portfolio can perform in up and down markets with less risk, as measured in terms of volatility.
3. Tax Benefits
Although few individual investors realize it, alternative assets can be held in retirement accounts and thus benefit from being tax advantaged. Alternative investments can be held in a traditional IRA, Roth IRA, SEP-IRA, Solo (k), 401(k) for sole proprietors and other types of qualified plans. Many investors frequently roll over 401(k) distributions into a retirement account.
Increasingly, many retirement savers are opening a Roth IRA to invest in alternative investments to allow high growth potential investments to realize tax-free distributions. Given the historical performance of alternatives, that’s a potentially significant benefit for investors.
In a well-diversified portfolio, alternatives give investors more ways to invest and find exceptional value or alpha. Direct investment alternatives provide an almost unlimited number of choices that can draw on the client’s business expertise or field of knowledge.
Direct investments can include private equity of every flavor, real estate, precious metals and notes, among others. All of those assets can also be placed in a tax-deferred account, except for an S corporation, arts, collectibles, life insurance and “prohibited transactions” that prevent investors from having direct control of the asset. Pooled or managed funds from investment sponsors provide an equally wide array of domestic and global choices. Whether inside or outside of a retirement account, both direct and managed alternatives provide a broader range of options for advisors and their clients.
5. Improved Client Satisfaction
There’s one other key reason for advisors to put client assets in alternatives: If they don’t, clients may look for another advisor. Demand for alternative investments is accelerating because investors want capital appreciation after a long period of meager equity returns. Conversely, those who serve as a trusted advisor and help clients conduct proper due diligence on alternative investments can strengthen client relationships. Few business development programs are better than happy clients who make referrals.
Financial advisors can play a big part in an alternatives strategy, particularly with direct investments. A financial advisor can help an individual prevent errors of judgment and potentially root out fraudulent investments. If they bring their wisdom and experience to bear, advisors and their clients all stand to benefit.
Read Top 10 Dangers of Alternative Investments on AdvisorOne.