[Pam Krueger is the founder of "WealthRamp" and co-host of "MoneyTrack" on PBS. The national spokesperson for The Institute for the Fiduciary Standard, she is a featured columnist for Investopedia. The views expressed by columnists are those of the author and do not necessarily reflect the views of Investopedia.]
How do the super wealthy invest their money? Beyond stocks and bonds, ever wonder what really rich investors' portfolios have that yours doesn't? The answer may be what’s known as "alternative investments." These are investments that represent a style of investing intended to protect wealth in the event of a big crisis or just everyday stock market turbulence. Think hedge funds as one example.
Most alternative investments were designed for the 1%. But now alternative investments are pushing into the mainstream. One reason is that alternatives are touted as investments that hint at potential higher overall returns on your money. This is critically important, especially to retirees trying to live off dividends and 1% interest as income to replace their old paychecks.
The whole purpose of introducing an alternative investment into your investment mix is simple: diversification. The reason is that when one asset type, such as a stock, goes down, the right different type of asset – real estate, for example – could be moving in the opposite direction from stock prices. The point is to protect yourself against downside risk. With a number of investors convinced that the stock market is overdue for a major tumble (see 3 Investors Who Think a Stock Market Crash is Coming), the smart money is increasingly looking for different ways to put their savings to work.
Alternative investments are finally becoming available outside of the 1% because prescient fund managers have started to focus on America's growing group of mass affluent investors. According to global consulting company McKinsey & Company, since 2005, global assets in alternatives have grown twice as fast as traditional investments.
Here’s a list of some of the alternative investments that can produce high returns that are uncorrelated to the stock market. Some are as esoteric as they sound. You might be comfortable putting some of your life’s savings into some of these alternatives, while others, not so much:
Just Because You Can, Doesn’t Mean You Should
Many financial advisors completely avoid investing in alternatives for one good reason: lack of liquidity. Traditional stocks and index funds are easy to track and monitor. Want to know what Apple's or Snap’s stock is doing today or what kind of dividend Coca-Cola’s paying? Type it into Google, and you can see it instantly. But investing in alternatives typically means holding on for at least five years. Tracking them requires a much deeper dive than a 60-second Google search. The lack of available current information translates into risk.
Alternatives are "off road" investments, and accurately monitoring the value of a private investment in something like real estate is anything but easy. A great deal of trust is involved with each and every transaction. How can you even understand how well an investment is performing without a standardized pricing system? All the same, according to Wealth Management, wealth managers say they plan to add more ‘alt’ investments to some client’s portfolios, increasing them from an average of 13% today to 18% by 2018.
Do Alternative Investments Work?
The real answer is sometimes. They can be incredibly useful, especially for hedging against risk during economic downturns. A study conducted by Informa Investment Solutions and published by BlackRock reveals that many alternative investments did provide protection over stocks during the 2001 and 2008 recessions because they didn't fall as much as stocks.
But these numbers look at alternatives as a whole rather than individual classes. It all depends on which alternative investment you're buying. For example, hedge funds had an atrocious 2016, despite how sexy they sound. After all, super-rich investors put their fortunes into hedge funds, so they must be good, right? Wrong.
Credit Suisse Capital Services found that hedge funds were hit hard by redemptions in 2016 because of the widespread underperformance across the board. More than 80% of investors redeemed some or all of their investment from hedge funds in the first half of the year, according to Credit Suisse's study. The study also revealed that more than half of those redemptions were due to specific managers' underperformance or strategy drift.
Alternatives are opaque. That's why it's important to choose funds managed by experts who specialize in them. If the trades aren't executed properly, you could wind up doing exactly the opposite of what you're trying to do – ramping your risk instead of reducing it. You could end up with subpar returns and oversized fees that disappear into fund managers' pockets.
But by far the biggest weakness with alternatives is that it can be nearly impossible to check the track records of these alternative fund managers, according to the Office of Compliance Inspections and Examinations (OCIE) of the SEC. There are usually no third-party verification and audits. Some financial advisors conduct their own due diligence, but real due diligence should be one of the services a fee-based fiduciary offers, according to the OCIE. The reality is that even they can't really see the level of detail needed to track performance. Often, they're just relying on the data provided by the funds rather than third-party performance data.
The only third-party option is to look for the fund's GIPS (Global Investment Performance) standards, although not all alt investments claim compliance with the standards. These standards provide "apples-to-apples comparisons" of performance data. Click here for a list of the firms that claim compliance, and check out the standards on the website to gain a fuller understanding of what compliance with them means. You'll probably notice that the list of funds claiming compliance is very short compared to the number of available investments. What's more, many individual investors and even some advisors don't seem to be demanding it. They're buying into non-compliant funds anyway.
Still Interested? How to Start
If you're going to incorporate alternative investments into your portfolio, how do you do it safely? Different types of funds make them convenient and accessible, and they're usually managed by experts other than your advisor – someone who specializes in a particular type of alternative investment.
Look for funds that have multiple managers, strategies or asset classes so you get more diversification for your investment dollars. Expect some sticker shock because all these alternative funds will come with higher fees than single-strategy funds. There's a lot more management going on within them than with a single-strategy fund.
It’s true you don’t need to be super-rich anymore to join the alternatives club, but you should be affluent enough to afford to invest in this way. Most wealth managers won’t touch this strategy unless you meet a certain minimum amount of total investable assets – typically around $2 million to $3 million. Most financial advisors outsource the job of actually watching over the investments.
And the Fees?
Right now, if you have a fee-only fiduciary advisor you’re likely paying less than 1% of the value of your invested portfolio (annually) to compensate for care-taking all your investments. You most likely expect proper diversification as part of the service in order to protect your money. Once alternatives enter the picture, you can expect those advisory fees to go up because of the outsourcing. That means your bottom line returns have to be that much higher to clear that hurdle.
How Much Is Enough?
Many advisors I talk to suggest allocating between 20% and 25% of your portfolio to private or alternative investments. The rest should go into traditional stocks, bonds and cash. Other experts insist on a much lower allocation. For example, Ed Butowsky, managing partner at Chapwood Investments told CNBC that he recommends investors have around 15% to 20%. How much depends heavily on your age, so it's important to work with a fiduciary advisor who can determine what percentage is best for you. In some cases, that might even be 0% of your portfolio.
Read more on this in Top 4 Alternative Investments to the Stock Market.