Exploring Alternative Investments: Do They Belong In Your Portfolio?

Along your investing journey, you may come across various investment prospects or a desire to invest in something unconventional.

I’m not talking about public stocks and bonds that everyone can buy. I’m referencing ‘alternative investments’.

What Are Alternative Investments?

Alternative investments refer to assets that are distinct from traditional investments such as stocks, bonds, and cash.

A few examples:

• Private Equity: investments in companies that have yet to go public, or buy out public companies.
• Private Real Estate Investment Trusts (Non-Traded REITs): investments in residential or commercial properties that are not available in the public markets.
• Hedge Funds: pools capital from accredited individuals or institutional investors and then utilizes a variety of strategies, such as short selling and leveraging, with the goal of generating high returns.

Benefits Of Owning Alternative Investments

• Higher Returns - you get access to non-public companies or opportunities that can be in their beginning stages, which sometimes leads to higher returns compared to say the S&P 500 index. Imagine if you were able to invest in Uber or eBay in the early stages. Once these stocks eventually went public, early investors were rewarded with massive returns.
• Diversification - if a majority of your net worth is allocated to traditional investments, you can further diversify your portfolio by investing in alternative investments.
• Generate income - investing in private REITs not only provides diversification to your portfolio, but these investments pay a strong dividend. Each REIT is different, but on average, you could expect around a 4% dividend yield on this type of an investment.

Disadvantages Of Owning Alternative Investment

1. Costs - you have to pay to play in this arena. These types of investments have higher costs compared to traditional investments. For example, the phrase associated with hedge funds used to be ‘2 and 20’. Meaning, you pay a 2% management fee and then a 20% performance fee, should the fund generate a return. That fee structure may be on the decline, nonetheless, it’s costly.

With non-traded REITs, the management fee can range from 1-2%, there can be a performance fee on top of that, AND there is usually an upfront fee that goes to the advisor/broker who sold you the product.

Don’t think those percentages seem high? Consider this, Jeremey Siegel provided the following analysis in his legendary book, Stocks for the Long Run:

Trading and advisory costs of 2 or 3 percent a year might seem small to investors who are gunning for 20 or 30 percent annual returns, but such costs are extremely detrimental to long-term wealth accumulation. Investing $1,000 at a compound return of 11% per year will accumulate to $23,000 over 30-years.

A 1% annual fee will reduce the final accumulation by almost a third.

With a 3% annual fee, the accumulation amounts to just over $10,000, less than half the market return.

2. Unclear Valuations - the beauty of investing in public markets is you know exactly how much your investment is worth by looking at the share price at any time. With alternative investments, this is not the case. These products are not publicly traded, so there is no market price readily available. These funds will have independent appraisals performed which may or may not be the true value if they were in the public marketplace.

3. Illiquid - should you need access to your money, and you are invested in traditional investments, you can sell those at any time. With alternatives, these investments are considered illiquid, which means you can’t easily convert the investment into cash.

Often these products require your money to be tied up for a certain amount of time or else you pay a ‘redemption’ fee. This time period varies. For non-traded REITs that can be as short as one-year, with private equity, your funds may be tied up for several years (maybe 4-10 years) before there is a liquidity event.

Also, consider when things start to turn, people run for the exits, and they, the private REIT, have the ability to stop redemptions.

So, should you need your money, and they are not accepting redemptions or offering a liquidity event, too bad…

Key Takeaways

In a low interest rate environment, like we saw over the past decade, investors sought higher returns. This resulted in taking on more risk and potentially investing in alternatives.

Let this serve as a reminder that, while there are benefits with these products, there are always risks, just like investing in traditional assets.

Understand the risk of your investments. Consider what would happen if an emergency came up and you needed access to your money. Ensure you have enough ‘liquid’ capital to cover these potential needs.

This podcast can be helpful to learn more about private equity and the implications we saw in 2022.

Also, never fun to see this story on a cover of a magazine…

Disclosure: This material is for general information only and is not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. All investing includes risks, including fluctuating prices and loss of principal.