Five Downsides of Investing in Alternatives

In recent years, investors have shown a great interest in non-traditional investments like private equity, private credit, property, valuable items, and others.

Based on a study conducted by Prequin, a research and analytics company, the worldwide alternative investments market is projected to reach a value of $18.3 trillion by the year 2027, which is a significant increase compared to the $9.3 trillion recorded in 2022. Over the period from 2015 to 2021, this market experienced an annual growth rate of 14.9%.

The growing desire for options - previously limited to large-scale investors - has emerged as investors endeavor to add value to their portfolios after a significant decline in both stocks and bonds. With the emergence of financial technology platforms, these previously exclusive opportunities, accessible only to well-connected and extremely wealthy investors, are now accessible to the general public.

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However, are alternative investments suitable for everyone? In contrast to public markets, alternative investments are considerably more intricate and have the potential to lock up investors' funds for prolonged periods. Although there are numerous advantages to alternative strategies, investors must also comprehend the disadvantages. Here are five factors to assess in order to ascertain if investing in alternatives is appropriate:

Extended time frames. Alternative investments possess an intrinsic lack of liquidity, resulting in the potential for investor funds to be locked in for approximately five to seven years, and in some cases, even up to ten years.

In spite of the increase in liquid alternatives (liquid alts), which enable access to alternative investments via mutual funds or ETFs, the actual investments are not easily convertible to cash. Therefore, to avoid being forced to sell the underlying asset, funds must restrict withdrawals.

The possibility of "barriers" and charges. In order to control the number of people withdrawing from a fund and avoid a sudden rush, liquid alternatives funds frequently implement a "barrier" if more than 5% of investors wish to exit the investment within a three-month period. This implies that once a fund surpasses the 5% limit, investors will be unable to withdraw their investment.

Investors might additionally be subjected to increased charges on these tactics, constraining their potential for earning a higher value in return.

3. Elaborate tax reporting. In contrast to stocks and bonds, which are declared to the IRS using a 1099-B form, alternative assets are in the form of partnerships that necessitate investors to submit Schedule K-1 forms. Such forms are considerably more intricate than 1099 forms as they lack a universal template.

Moreover, due to the fact that the primary organization is required to submit its business tax return beforehand, the documents tend to be received at a much later date, usually in March or April, or sometimes as far as autumn if an extension is filed by the company, thereby creating challenges in the process of tax filing.

4. Absence of oversight. As alternative investments function through limited partnerships, the fund manager possesses full authority and can determine the investment duration and timing of selling.

This approach could be suitable for an endowment or an individual with an incredibly significant amount of wealth. However, it could present challenges for someone who possesses less immediate capital.

5. Possibility of subpar performance. Research from Dimensional reveals that between June 2006 and June 2022, American liquid alternative funds have demonstrated lower performance compared to comprehensive benchmarks that monitor stock and bond markets.

Besides poor performance, liquid alternatives may also lack appropriate diversification, which has traditionally been a primary motive for investing in this asset category, as these funds are constructed based on the same principles as the global equity and fixed income markets.

Cautionary Considerations For Investors

As substitutes have gained significant traction and acceptance, it is crucial for investors to diligently contemplate various aspects prior to considering investment in such a tactic. Do you foresee the necessity to retrieve your funds in the near future? Are you prepared to incur elevated charges or possibly encounter limitations that hinder your ability to withdraw from the investment? Do you possess the competence to handle intricate obligations of tax reporting?

Options can serve as a useful approach for establishments, foundations, and extremely wealthy investors who possess surplus cash reserves and can entrust the supervision of these approaches to their larger teams. However, individuals with limited investment capabilities should carefully reflect upon their objectives and approaches prior to making any decisions. It is often possible to attain similar financial results by constructing well-balanced portfolios containing conventional stocks and bonds.

ALINE Wealth comprises a team of investment experts who are officially registered with Hightower Securities, LLC, a member of FINRA and SIPC, as well as Hightower Advisors, LLC, a registered investment advisor regulated by the SEC. Hightower Securities, LLC facilitates the offering of securities, while Hightower Advisors, LLC provides advisory services.

This post was authored by and reflects the opinions of our contributing consultant, rather than the Kiplinger editorial team. You have the option to verify the consultant's credentials by consulting the SEC or FINRA.