Survey Finds Increasing Demand In Alternative Investments For Investors

The stock market has made a surprising comeback this year, ending the longest bear market since 1948 in June. 

The benchmark S&P 500 index has risen 19.34% year to date, while the tech-heavy Nasdaq Composite index notched an impressive 36.78% rise so far this year, ending the 2022 tech rout. 

But concerns regarding an impending recession have failed to ease, with the Federal Reserve hiking interest rates in July after a temporary pause in June. As a result, investors have been hedging against a potential stock market crash by diversifying their portfolios to integrate alternative investment instruments. 

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The Push Toward Alternative Investments 

According to the 2023 Trends in Investing survey conducted by the Financial Planning Association (FPA), investment professionals are implementing varying strategies for diversifying client portfolios using alternative assets. Out of 191 qualified respondents, 28% of advisers stated that they actively invested in or sought alternatives for their clients' portfolios. 

Additionally, 19% reported staying up-to-date with research on alternatives and considering allocating a portion of their clients' portfolios to the asset class within the next 12 to 24 months, although they had not implemented this approach yet.

Private equity ranked as the dominant alternative asset class at 23%, with structured products following closely behind at 21%. 

Aaron Hodari, a certified financial planner who serves as the chief investment officer and managing director at Schechter Wealth, said private debt is rapidly gaining popularity as one of the primary alternative products favored by investment professionals.

"Historically, private debt has very low volatility and very high cash yields. On top of that, most of the private debt market is floating rate. So in a year like last year, when we got rising interest rates really hurting bonds, private debt — in absolute terms — had positive performance," he said.

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Interval funds are an emerging asset class that provides a "transparent, user-friendly approach to utilizing alternatives" and generally come with relatively lower fees compared to other private market products, Hodari said.

"For an adviser who wants to get into alternatives, it's hard to imagine your first alternative will be the typical eight- to 12-year private equity locked-up fund that you're not going to know how it's performing for four to five years. The interval fund structure allows advisers to dip their toes into the market in a much more flexible way," he said.

Diversification is one of the key objectives mentioned by 55% of respondents while branching out to alternatives, followed by 41% seeking risk mitigation. Approximately 25% of the respondents considered upside growth potential, while 24% and 23% stated protection against inflation and income generation among their primary goals, respectively.

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Liquidity Issues: The Major Deterrent 

Approximately 30% of the FPA survey respondents stated that they avoid alternative assets despite having a fundamental understanding of the asset class. In addition, approximately 41% of the investment advisers responding to the survey cited issues about fees and expenses as a major concern.

"It's just really tough to get out of some of these funds," said Chris Mellone, a partner at VLP Financial Advisors. 

While these are frequently voiced concerns from investors, Hodari said, "When we talk to a client, we never get that pushback. The reason is before we make a recommendation of an investment, we've already set the stage through financial planning for what does our portfolio need to do over time? What are our cash flow needs?" 

Alternatives can serve as an ideal asset class even in retirement, provided investment advisers strategically allocate the assets, Hodari said. 

"Even in retirement, when a typical client is taking 4% of a portfolio per year, if you have 20% of the portfolio locked up, that is not going to impact that ability to take withdrawals. While you need to be mindful of [liquidity] and plan around it based on the client's situation, if you're being judicious in the usage of illiquidity, that is not a challenge from a portfolio manager perspective," Hodari said. 

While some alternative asset classes bear a higher risk parameter, several assets, including real estate, private debt and private equity, have historically proven to generate substantial returns. 

If you're trying to build a diversified portfolio and capture return in multiple market environments, lower correlation with the stock market and increase the chances for success, diversifying your exposures across more asset classes that have a positive expected return is, in my opinion, the only way to really properly build a portfolio to meet that client's plan," Hodari said. 

Investment advisers must be well-versed in a client's financial goals and objectives, short-term liquidity needs and potential tax liabilities before making a recommendation comprising alternative assets.