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How Advisors Offer Alternative Investments in 2021

William Freedman

Topics: Retirement, API, Trust Platform, Investment Advisors

We’ve discussed in this space how registered investment advisers and their representatives can turn big-picture challenges into opportunities. A sudden shift in policy as a new administration took office in Washington? The Great Resignation putting a dent in recruiting? RIAs didn’t just survive these. They thrived. 

 

And one of the reasons is that RIAs, even though they must act as fiduciaries, have the latitude to recommend alternative investments to their clients as part of a balanced portfolio. Alternatives are essentially all kinds of assets aside from stocks, bonds, and mutual funds. They are high-risk and, in aggregate, high-reward -- which means, in particular, any of them could go bust. Considering that mineral rights are one form of alternative investment, "dry well" is more than a metaphor. 

 

Of course, just because RIAs and their representatives are permitted to recommend alts doesn’t mean they always should. They have to act in their clients’ best interests, and not everything on this smorgasbord is on every investor’s diet. 

 

Alternative reality 

So what exactly is on the menu? In a previous post, we listed: 

  • Cryptocurrency,  
  • Horses and livestock,  
  • Intellectual property,  
  • LLC membership interests,  
  • Mineral rights,  
  • Precious metals,  
  • Private equity,  
  • Private debt, 
  • Promissory notes, 
  • Real estate, 
  • Tax lien certificates, 
  • Water rights, 
  • Collectibles and 
  • Life insurance discounts. 

 

With the exception of the last two, they can be held in self-directed retirement accounts. Of course, RIAs aren't likely to deal with all of those. They generally concentrate on private debt, private equity, hedge funds, mineral rights, and real estate -- specifically commercial real estate. 

 

“[I]nstitutional and private clients have been increasingly turning to these investments not just to supplement traditional long-only stocks and bonds but also sometimes to replace them altogether,” according to the CFA Institute. “On average, pension funds in developed markets increased their allocation from 7.2% to 11.8% of assets under management (AUM) in 2017, a 63% increase.” 

 

While RIAs and their representatives fall under the watchful eye of the Securities and Exchange Commission, these particular investments tend not to. As a result, these are best directed at accredited investors -- basically those with $200,000 in annual income or $1 million in the bank. (Note: Primary residence doesn't count. Nobody lives in a bank.) Alts are generally illiquid, so the payday might be years out. Clients don't like it when they're millionaires on paper but are having their third ramen noodle-based meal of the day. 

 

Under the right circumstances, though, a limited number of non-accredited investors can be brought into the equation. If securities are being offered under Rule 506(b) of Regulation D of the Securities Act of 1933, then up to 35 investors in the private placement of debt or equity can be non-accredited. Also, if a vehicle such as a mutual fund that trades on a regulated exchange serves as a portfolio of alts, any investor can buy into that. 

 

Still, even though certain clients are financially capable of taking the leap into alts, isn't enough of a justification for advising them to do so. According to JPMorgan Asset Management, their alts bring three benefits to a portfolio. They call these AID, an acronym for alpha, income, and diversification. Of course, any given portfolio could require more A than ID, or more I than AD. And those needs are given to changing over time. 

 

"[T]he AID from alternatives is accelerating their transition from optional to essential portfolio components," the Morgan authors write. "A strong investment framework will include outcome-driven insight and analytics-based allocations. That will bolster investors as they look to alternatives for the alpha, income, and diversification they need." 

 

And yet, advisors seem to be shy about offering alts. According to BlackRock, only one out of four model portfolios includes them. That won't last forever. There's a good chance that an RIA that doesn't offer alts could be leaving its clients' money on the table. And there's almost as good a chance that they'll notice. 

 

Understand your Asset Classes  

Offering alts could be as low-impact as mixing in real estate investment trusts along with stocks, bonds, and mutual funds. The trick then becomes to emerge as an expert in one or more of these asset classes that other RIA representatives aren't watching so closely. 

 

None of this is to denigrate REITs. It’s just that there’s very little difference between an exchange-traded REIT and an exchange-traded mutual fund. 

 

But advisors who understand REITs have a head start in understanding commercial real estate more broadly and can more credibly recommend participation in LLCs formed to construct or manage a specific project. These advisors could then starburst into private debt, as there is a market for notes connected to the bridge loans builders require to smooth out their access to pre-revenue cash. Once tenants are moved in, these bridge loans are generally paid off by lower-interest rental loans, and again, there's a market for those. And this is quite apart from the market for private mortgages. 

 

Once an RIA has developed expertise along these lines, it’s just a short stretch to private debt more broadly, and from there to private equity, and from there to venture capital. 

 

One quick caveat: These financial alts generally require a minimum investment. Make sure your client can afford to get into these games. 

 

Overdue diligence 

Let's define what we mean by expertise. Yes, it means familiarity with the market, but that's only part of it. To be an expert in a specific alt -- or any investment vehicle -- you need to know the fundamentals as well. 

 

Valuation is hard enough with stocks: EPS, P/E, PEG, ROIC -- it’s an alphabet soup of metrics. But at least you don’t have to distinguish between any two shares of the same company and class. One is exactly like all the others. 

 

REITs are kind of like that, but take the example on the extreme far end of the spectrum: What about collectibles? What makes a particular Maclaren worth more than a particular Bentley? What makes one painting worth tens of millions of dollars at Christie's and another worth $50 at a flea market? What makes one bottle of wine worth $30,000 and another free with a Thanksgiving turkey? You're not going to pick this up for free on Squawk Box. You need to come by this expertise honestly through thorough research. Your clients have every reason to expect not just sound advice but that the advice is based on an objective and independent perspective -- one they can't get off of Squawk Box for free either. 

 

But whether we're talking about REITs or collectibles or fractional ownership of racehorses, you need to be able to quantify value. And risk. And have a clear-eyed view of how long your client is likely to be locked into a particularly illiquid investment. 

 

Of course, you also need to understand how you'll be reimbursed for your expertise. As you develop your reputation and performance history in your chosen asset class, you'll need to adjust your fees to match those of similarly skilled advisors. 

 

Notice how we parsed "reputation" and "performance history." The latter is quantitative; the former is not. Reputation has as much to do with how well you communicate with your clients: setting realistic expectations, explaining risks, and remaining transparent.  

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