'Big Opportunity, Big Risk': What Clients and Advisors Must Know Before Investing in Alts

With their potential for higher returns, alternative investments represent a big opportunity — and a big challenge, she points out. One pressing issue is that alts can become illiquid.

"Clients need to understand that," says D'Auria, who has been managing and implementing solutions for advisors for more than 15 years.

While she sees "great potential" in President Donald Trump's push to use alts in 401(k) plans, "done poorly," D'Auria cautions, "it can be a real problem."

In the interview, the fintech executive unpacks the primary risks and rewards that alts bring to investment portfolios. Her advice: "Pay attention to the warnings and disclosures."

Here are excerpts from our conversation:

THINKADVISOR: What's all the excitement about alternatives?

DANA D'AURIA: I've been in this industry for 20 years. There's been an effort to sell alternatives to financial advisors for as long as I can remember. This time it's serious, and we think advisors really need to pay attention. We believe the adoption of alts in the wealth space is finally going to increase in a substantial way.

THINKADVISOR: Why?

D'AURIA: There are so many companies that want to stay private longer and a lot of innovation in the private market space as opposed to public companies. 

So you have more and more of that information going out to the public. Clients are going to expect their advisors to be able to navigate this space and offer solutions.

I do think alts are a big opportunity as well as a challenge. It's one of the most important sea changes going on in the industry. Big opportunity, big risk.

It's a very important issue and something that the retail advisory space needs to be able to tackle. Platforms like ours help them do that.

THINKADVISOR: What is the advisor sticking point?

D'AURIA: There are two major issues that advisors have to contend with in offering alts to the retail space that make it complex. One is liquidity. These vehicles that are called semi-liquids, like interval funds, tender offer funds, private [business development companies], private REITs, offer great opportunity to allow a client who doesn't want a drawdown fund to still participate in the alternative space.

But you do have to remember these may become illiquid. That's the risk. There's probably going to be a lockup, and they'll have more redemption requests than these funds can manage. A client has to accept that they can't get out. So you're not going to be able to demand liquidity at a bad time. 

For better or worse, you're kind of stuck with [them]. And the client needs to understand that.

THINKADVISOR: Are these investments appropriate only for high-net-worth and UHNW folks but not for those with lower asset levels?

D'AURIA: With the right education, certain products can be relevant to the mass affluent for sure.  

It has to be something like an interval fund, where there's no accreditation requirement. Somebody who's working at a job and contributing to a 401(k) has to understand that it's potentially going to be locked up for the next 30 years, if they're a young person. 

So why not give them access to something that could build and compound over time along with an illiquidity premium? But it has to be made super-clear: They're not going to have access to that money, depending on the market and underlying instruments.  

THINKADVISOR: If a client asks whether an alt would be appropriate, what's a good answer?

D'AURIA: It should be a nuanced answer. Coming down on one side or the other isn't a great answer. For one, they're not telling all your options on the other side.

 I don't believe in cutting anything off. It's our job as an industry to figure out how to best use these instruments to better clients' retirement,their long-term goals.

THINKADVISOR: What are your thoughts about President Donald Trump's interest in using alts in 401(k)s?

D'AURIA: Done right, that has great potential. Done poorly, it can be a real problem. You need to tell people this is an instrument that you have to be willing to sit with for, potentially, years. But the benefit can be compounding at a higher rate over time.  

THINKADVISOR: You've said that advisors are increasingly rushing into alts but that many don't fully understand how these products work, how liquidity windows operate or where they belong in a portfolio. So is the underlying issue that advisors need alts education?

D'AURIA: That's exactly right. It really boils down to education that our industry needs to do. It requires a whole new set of educational elements for the advisors to get access to. 

The opportunity is great, but it's going to require significant education both at the asset class level and individual product level as well as good communication back to the client and an understanding of their financial plan. Can they afford to put money into this?

The [alts] education gap is one of the biggest risks in wealth management: If you put people into these instruments and they don't realize they can't get their money out, it could be a severe problem.

So one issue is the liquidity, and the other is that dispersion and performance in alternative funds is much greater than in public-market equity and fixed income funds.

You have a nice opportunity to diversify your exposure and potentially get higher returns than you can get in the public market. 

But that doesn't mean you're going to get Calpers [California Public Employees' Retirement System]-like returns. You're not going to get Yale[-like] returns, where they have access to the best managers, the best deals. 

In private equity, it's much more likely to be widespread in performance versus public equity.

THINKADVISOR: I would think advisors should tell clients all the aspects of alts up front. Right?

D'AURIA: How do we make sure the advisor is well informed and in turn is informing the client thoroughly before they ever enter the instrument? 

It's making sure that their understanding is complete. For example,there's a slim possibility for a misunderstanding about the liquidity features.  

You really have to be paying attention to the warnings and disclosures.