Does Your Portfolio Actually Need Alternative Investments
In the past few years, alternative investments have surged in popularity among retail investors looking to diversify beyond the perceived limitations of traditional stocks and bonds. Once reserved exclusively for the ultra-wealthy and institutional investors, alternative investments—including private equity, real estate, private credit, hedge funds, farmland, and even collectibles like art and wine—are now more accessible than ever.
Today, the appeal of this alternative asset class lies in its potential for outsized returns. However, it was initially intended to provide investors with a hedge against inflation, as well as the promise to reduce a portfolio’s correlation with the stock market, which offers a buffer in times of volatility. Therefore, it is possible that there is a misunderstanding between the banks, brokerages, and other financial institutions offering alternatives to retail investors and the investors who are eagerly embracing them.
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When an investor is considering whether to include alternatives in their portfolio, it is important to first consider the intended purpose of putting those dollars to work and whether the particular alternative investment in question is capable of delivering such a result. Without this clear alignment between goals and the chosen investment, alternatives can quickly become an unnecessary layer of complexity rather than a meaningful addition to the portfolio.
As new platforms and products open the door to smaller investors, the minimum investment requirements that once made these assets inaccessible to all but the top 1% of investors have lowered significantly. Crowdfunding platforms, for instance, now allow retail investors to buy fractional shares of commercial real estate or art, while certain private equity and hedge funds have introduced “retail” versions of their flagship funds with much lower buy-ins and shorter lock-up periods—otherwise known as “liquid alternatives.”
While lower barriers to entry may appear to democratize wealth-building opportunities, they also expose more investors to complex and high-risk markets where losses can be severe. Additionally, alternatives frequently lack the transparency associated with publicly traded assets, meaning the fee structures in alternative investments are often more opaque and considerably higher than those of traditional assets, eroding returns for those who lack sufficient capital to absorb the costs.
These products may charge expense ratios well above those of index funds or even actively managed mutual funds, often approaching the “2 and 20” fee model associated with institutional hedge funds, meaning 2% of assets under management and 20% of profits above a specified threshold. However, retail investors typically don’t see the same level of active management, research, or outperformance that such fees are meant to justify.
Thus, when it comes to retail investors gaining access to liquid alternatives, the playing field can be far from even. Fund managers creating these products are often constrained by regulatory requirements that limit their ability to hold truly illiquid or high-conviction assets. As a result, many liquid alternative funds are populated with what could be described as "second tier" investments.
For example, a hedge fund specializing in distressed debt might concentrate the assets within its institutional fund among a handful of deeply researched opportunities, while the retail version of the fund is forced to spread its bets across a broader, less compelling pool of securities to maintain daily liquidity. This often leads to diminished performance that falls short of the returns delivered by traditional hedge funds.
While it may be true that investing in alternatives requires a level of expertise and due diligence beyond what is needed for publicly traded stocks and bonds, it is absolutely true that investors in alternatives need a high capacity to take on the additional financial risk. In private equity or venture capital, for example, investors may face a greater chance of failure or long stretches without liquidity, as these investments typically take years to mature.
Conversely, institutional investors, such as family offices, private foundations, pension funds, and endowments often have long-term investment horizons and a mandate to seek stable, diversified returns to meet future liabilities. For example, a university endowment with a 50-year time horizon might allocate to private equity or venture capital to achieve outsized returns, while balancing those investments with stable income-generating assets like real estate.
Alternative investments are certainly having their moment in the spotlight, capturing the attention of retail investors who have traditionally been relegated to the public markets. And for some investors, alternatives may indeed serve as a valuable tool for diversification and long-term growth. The drawbacks for others, however, may outweigh the potential rewards.
In many cases, retail investors can achieve similar levels of diversification and returns through traditional means, such as a well-balanced mix of stock and bond investments, supplemented by exposure to real estate investment trusts (REITs) and commodities via exchange traded funds (ETFs) or mutual funds. Using this approach, retail investors can often replicate many of the benefits—such as diversification and inflation protection—through simpler and more cost-effective vehicles.
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Malcolm Ethridge, CFP® is the Managing Partner at Capital Area Planning Group, based in Washington, D.C. He is also the Managing Partner of Capital Area Tax Consultants.
Malcolm’s areas of expertise include retirement planning, investment portfolio development, tax planning, insurance, equity compensation and other executive benefits.
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Disclosures:
The information provided is for educational and informational purposes only, does not constitute investment advice, and should not be relied upon as such. Be sure to consult with your legal advisors before taking any action that could have tax and legal consequences.
Investments in securities and insurance products are:
NOT FDIC-INSURED | NOT BANK-GUARANTEED | MAY LOSE VALUE