Five Downsides of Investing in Alternatives

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Over the past couple of years, investors have demonstrated a strong appetite for alternative investments such as private equity, private credit, real estate, collectibles and more.

According to research and analytics firm Prequin, the global market for alternative investments will be $18.3 trillion by 2027, up from $9.3 trillion at the start of 2022. From 2015 to 2021, the market grew at a rate of 14.9% annually.

The increasing demand for alternatives — once exclusively the province of institutional investors — comes as investors seek to inject alpha into portfolios following a historic double-digit down year for both stocks and bonds. With the rise of fintech platforms, these opportunities, which were previously reserved only for well-connected, ultra-high-net-worth investors, are now fully available to the masses.

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But are alternative investments right for everyone? Unlike public markets, alternative investments are far more complex and can potentially tie up investor money for years at a time. While there are many benefits to alternative strategies, investors must also understand the downsides. Here are five aspects to consider when determining whether to invest in alternatives:

1. Longer time horizons. Alternative investments are inherently illiquid, meaning investor money could be tied up for roughly five to seven years — or even up to a decade.

Despite the rise of liquid alternatives (liquid alts), which make alternative investments available through mutual funds or ETFs, the investments themselves are illiquid, so funds must limit redemptions to prevent them from having to sell the underlying asset.

2. The potential for “gates” and fees. To limit redemptions and prevent a run on a fund, liquid alternatives funds will often impose a “gate” if more than 5% of investors want to exit the investment per quarter. This means that once a fund reaches the 5% threshold, investors will not be able to exit the investment.

Investors may also have to pay higher fees on these strategies, which limits their potential return value.

3. Complex tax reporting. Unlike stocks and bonds, which are reported to the IRS via a 1099-B form, alternative assets are partnerships that require investors to file Schedule K-1 forms. These are far more complex than 1099 forms because there is no standard format.

Additionally, since the underlying company must file its business tax return first, the forms arrive much later, typically in March or April, or even as late as the fall if the company files an extension, making tax filing more difficult.

4. Lack of control. Since alternative investments are limited partnerships, the fund manager holds all the control and can decide how long to invest and when to sell.

This might work well enough for an endowment or an ultra-high-net-worth investor who is sitting on piles of money, but it might be a problem for someone with less cash on hand.

5. Potential for underperformance. Data from Dimensional found that from June 2006 to June 2022, U.S. liquid alts funds have underperformed broad indexes that track equity and fixed-income markets.

In addition to underperformance, liquid alts may not offer appropriate diversification — which has long been a key reason for investing in this asset class in the first place — as these funds build on the same foundations as the global stock and bond market.

Investors should think carefully before diving in

While alternatives have become more popular and mainstream, investors should think carefully about all the factors before investing in this type of strategy. Will you need access to your money in the near term? Are you willing to pay higher fees or potentially run into gates that prevent you from exiting the investment? Do you have the wherewithal to manage complex tax reporting requirements?

Alternatives can be an effective strategy for institutions, endowments and ultra-high-net-worth investors that have excess cash reserves and can leave the management of these strategies to their larger teams. But smaller investors should think carefully about their goals and strategies before making a commitment. You can often achieve the same financial outcomes through well-diversified portfolios composed of traditional equities and fixed income.

ALINE Wealth is a group of investment professionals registered with Hightower Securities, LLC, member FINRA and SIPC, and with Hightower Advisors, LLC, a registered investment advisor with the SEC. Securities are offered through Hightower Securities, LLC; advisory services are offered through Hightower Advisors, LLC.

Disclaimer

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

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Peter J. Klein, CFA®, CAP®, CSRIC®, CRPS®, is the Chief Investment Officer and Founder of ALINE Wealth, a wealth management firm that specializes in providing clients with financial planning advice for every stage of their lives. Along with Peter’s deep financial wisdom, he adds considerable acumen in philanthropy, helping clients navigate family trusts, institutions, and nonprofits.