Alternatives are on the rise: Why it may be time to consider adding alternatives to your clients’ portfolios

Alternative investments are increasingly mainstream and on investors’ radars. Connection Capital found in June 2020 that 87% of investors were planning on maintaining or even increasing their allocation to alternatives, and Preqin estimates that alternative assets under management could grow to $17 trillion 2025 from $10.7 trillion in December 2020. As an RIA, it is important to understand the risks and opportunities alternatives present in order to advise your clients on which investments align with their investment needs.

Several trends drive investor interest in alternatives

The rise in investor interest is driven by a confluence of trends. First, despite stock market returns north of 50% over the past year, many investors are worried about the market outlook going forward. Stocks continue to hit record highs, although they appear overvalued by some metrics, and many investors wonder whether valuations are sustainable. On top of that, the past 18 months have delivered record levels of market volatility.

A second factor driving the trend is today’s low interest rate environment. Traditional safe haven investments such as high-yield savings accounts, CDs and bonds are returning next to nothing, and the 10-year Treasury yield currently stands around 1.31%, which is less than inflation. Combined with pessimism around the stock market, this is bad news in the long term for the traditional 60/40 portfolio. Although 60/40 portfolios are up over 30% year-over-year, in the years ahead investors will need to branch out in order to continue achieving superior returns.

A third factor driving interest in alternatives is the role the 2012 JOBS Act had in democratizing alternatives. Previously, only accredited investors were able to access most alternative investments. The Act broadened access to a wider universe of retail investors and led to a flurry of activity in the alternatives space. A wide range of crowdfunding and other technology-enabled platforms created new opportunities for investors to access a much broader range of alternative investments, including venture capital, private equity, private debt, and farmland, which previously had only been accessible to institutions and the extremely wealthy who could afford the high minimum investment thresholds and increased diligence costs.

The key takeaway here is that alternatives are here to stay.

The benefits of adding an allocation of alternatives to your clients’ portfolios

Alternative investments are more than just hype – they have many characteristics that make them an attractive choice for augmenting your client’s portfolio. Three attractive characteristics of alternatives are returns, diversification and income.

First and foremost, alternatives are a way for you to help your clients achieve alpha. For example, between 1992 and 2020, farmland outperformed both the stock market and gold. Adding an allocation of farmland to a traditional 60/40 portfolio increased returns over this time period from 6.9% to 7.5% and reduced volatility from 10.5% to 8.9%.

Second, alternatives are uncorrelated with the stock market, making them an excellent choice for increasing the diversification and reducing the overall volatility of a client’s portfolio. Farmland is uncorrelated with all major asset classes, including stocks, bonds, commercial real estate and gold. Notably, the NCREIF farmland index has experienced only two quarters of negative returns since 1992.

Third, many alternative investments provide passive income, which can be an excellent way of augmenting and diversifying your clients’ streams of cash flow. This can be particularly beneficial for retirees or others on a fixed income. For example, in addition to price appreciation, farmland delivers passive income in the form of periodic rental and crop payments. For this reason, the right alternative investment can provide a higher-yielding substitute for bonds in a clients’ portfolio.

For all these reasons, it is worth considering an allocation of alternatives. Morningstar recommended that an allocation of 3% – 10% to alternatives was appropriate for retail investors. Depending on your client’s risk tolerance, investment horizon and financial goals, alternative investments can provide an excellent mix of above-market returns, diversification and passive income that cannot be achieved through traditional public market investments alone.

Technology-enabled platforms make alternatives more accessible than ever

While alternative investments offer clear benefits, many Registered Investment Advisors (RIAs) have faced challenges in offering these strategies to their clients. Historically, barriers such as high minimum investments, lack of transparency, and limited access to quality managers made it difficult to incorporate alternatives into client portfolios. However, technology-enabled platforms are addressing these hurdles, providing RIAs with streamlined access to a wider range of alternative investments, often with lower minimums and greater transparency.

Despite these advancements, a knowledge gap remains a significant obstacle. According to investment experts, around 67 percent of advisors report that a lack of understanding prevents them from investing more heavily in alternatives. With the diversity of the alternative investment space, it’s essential to have a broad understanding of how different asset classes function. For example, farmland investing shares similarities with real estate but has key differences, such as varying crop risks and cash flow profiles, making it vital to tailor strategies to each client’s needs.

Help your clients leverage the benefits of alternative investments

Alternative investments can form a key component of a comprehensive investment strategy by providing above-market returns, improving diversification and providing passive income. As they become increasingly mainstream, it is more important than ever for RIAs to have a solid grasp of several alternative asset classes.