Alternative investments are an area of increased interest for many investors as they offer additional diversification to traditional stocks and bonds, can provide a buffer against volatility, and may enhance the overall performance of your portfolio. While it is true that alternatives often provide an opportunity for enhanced returns and diversification, they also come with added risk.
How do you decide if an allocation to alternatives is right for you? The following tips can help.
#1 – Research the various types of alternatives.
The term “alternative investment” refers to a broad range of investment types, all with their own styles, return characteristics and risks. Common alternative investments include the following.
- Private investments – These include private equity, private debt, private real estate, private infrastructure, etc.
- Real estate – This includes direct investments in physical properties as well as purchasing shares in a real estate investment trust (REIT) or real estate mutual fund.
- Commodities – These include timber, agricultural products, oil, etc.
- Hedge funds – These refer to pools of assets managed by professional fund managers on behalf of high-net-worth investors. Hedge funds often involve complex trading strategies designed to produce higher-than-average returns, and they typically carry correspondingly high risks.
#2 – Determine whether an allocation to alternatives fits into your overall investment strategy and financial plan.
An allocation to alternatives may make sense if you are able to tolerate the risks without derailing progress toward your long-term financial goals. Alternatives have the potential to help those who are seeking:
- Diversification – One of the main reasons to invest in alternatives is that they tend to have low correlation with traditional asset classes. That means they do not follow the typical volatility of stock and bond markets. This low correlation offers an opportunity to smooth out your overall investment performance during periods of market volatility.
- Inflation protection – If you are looking for a hedge against inflation, certain alternatives, such as commodities and real estate, can help preserve the long-term purchasing power of your portfolio.
- Enhanced returns – Alternative investments have the potential to generate higher returns than some traditional investments. For example, private equity and venture capital investments provide an opportunity to participate in the growth of early-stage start up companies, which can lead to significant gains if the companies succeed.
- Tax benefits – Certain alternative investments offer tax benefits. For example, investments in energy can provide tax credits, while investments in real estate often offer tax deductions for depreciation.
#3 – Understand the risk.
While there is a potential upside to incorporating alternatives as part of your diversified portfolio, there are also significant risks that you should be aware of prior to investing.
- Illiquidity –In many cases, investing in alternatives requires that your money be locked up for a period of time. For example, an investment in real estate may require that you sell a property (potentially at a loss) in order to gain access to your funds. Some alternatives remain illiquid for a decade or more.
- High fees –Alternative investments often have higher fees than traditional investments. These can include management fees, performance fees and other administrative costs, all of which have the potential to significantly reduce your net returns.
- Complexity –Alternatives often involve complex investment structures that can be difficult to understand and can lead to significant tax complexities. And, because these investments are typically privately managed, they are not held to the same reporting and pricing standards as traditional investments. This means you may not have the same level of transparency you are used to.
- Regulatory risks –Alternative investment managers are not as heavily regulated as public investment managers. That is why it is important to take time to properly vet any potential managers to help ensure they do not expose you to risks such as investment mismanagement or fraud.
#4 – Conduct in-depth due diligence to identify the right options for you.
Given the complexities and potential risks of investing in alternatives, it is important to conduct an in-depth analysis of any potential investment prior to committing. Your financial advisor can help you evaluate various opportunities and find a solution that makes sense for you, given your personal financial situation, other investments, risk tolerance, future goals, etc.
Are you considering diversifying your portfolio with an allocation to alternatives? We would love to help. To speak with one of United Capital’s qualified advisors, contact us.
