Do Alternative Investments Belong in Most Individuals' Portfolios?

Do Alternative Investments Belong in Most Individuals’ Portfolios?

Do Alternative Investments Belong in Most Individuals’ Portfolios?

Alternative Investments: A New Opportunity for Mainstream Investors

In recent times, alternative investments have expanded beyond the realm of deep-pocketed institutions and the wealthy elite. Investment firms have introduced a diverse range of alternative offerings, making them accessible to the less affluent. These options include private-equity funds with manageable initial investments, as well as mutual funds and exchange-traded funds (ETFs) that employ hedge-fund-like strategies.

The response from individual investors has been overwhelmingly positive, with tens of billions of dollars flowing into these new offerings. According to fund tracker Lipper, assets under management in alternative mutual funds surged from $180.4 billion to $317.9 billion by March, indicating the growing popularity of these investment vehicles.

Do Alternative Investments Belong in Most Individuals' Portfolios?
Do Alternative Investments Belong in Most Individuals’ Portfolios?

The Growing Appeal of Alternative Investments

Supporters argue that the mainstreaming of alternative investments is a significant financial innovation that is here to stay. When utilized appropriately, alternatives can offer individuals some of the same benefits that have long been attractive to institutional investors.

However, critics contend that just because individuals can now invest in alternatives doesn’t necessarily mean they should. They raise concerns about high fees, excessive risk, and a lack of transparency associated with many alternative products. These critics advocate for the tried-and-tested approach of a low-cost indexed portfolio that is regularly rebalanced over time.

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Yes: If Used Right, They Offer Diversification and Options

Do Alternative Investments Belong in Most Individuals' Portfolios?
Do Alternative Investments Belong in Most Individuals’ Portfolios?

The endowments of esteemed institutions like Yale and Harvard have consistently achieved impressive average annual returns of 13.5% and 12%, respectively. They have done so by relying heavily on private equity and other alternative investments. While the strategies employed by these institutions might be beyond the reach of most people, the retail market has seen a surge in alternative offerings that cater to individual investors.

Publicly traded private-equity firms, mutual funds, and ETFs have made nontraditional assets more accessible than ever, with manageable initial investments and fees comparable to traditional mutual funds. When utilized correctly, these alternatives can indeed offer diversification, a broader range of investment opportunities, and even access to leverage.

The Permanence of Alternative Investments

Alternative investments are not just a passing fad; they address certain economic shortcomings that traditional investments often fail to overcome. For instance, private-equity funds and activist hedge funds create value by taking controlling stakes in companies and aligning the interests of owners and management. Such alignment is rarely found in the stock market, where retail investors typically lack the influence to impact executive decisions.

One standout example is Berkshire Hathaway, a favorite among stock pickers, which behaves more like a private-equity firm, emphasizing long-term investments and values-based decision-making that aligns managers with owners.

While critics might be skeptical of alternative investments, it is essential to recognize that all investments carry some level of risk. Instead of focusing solely on the potential for outsize returns, investors should prioritize diversification, which is crucial in mitigating portfolio risks without sacrificing returns. By replacing a portion of a traditional portfolio with a mix of alternative products, investors can reduce volatility and slightly increase returns, as per research from Robert W. Baird & Co.

Moreover, alternative asset classes can offer specific protections against certain risks. For instance, a business owner heavily dependent on fuel prices could use an accessible, inexpensive hedge that shorts oil to balance their personal portfolio effectively.

The Myth of Complexity

One of the myths surrounding alternative investments is the perception that they are challenging to evaluate. However, thanks to the internet, individuals now have access to the necessary information to research, analyze, and compare various alternatives from the comfort of their homes. With a bit of research and self-education, investors can make informed decisions about alternative asset classes.

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No: They Aren’t Worth the Expense and Risks

Do Alternative Investments Belong in Most Individuals' Portfolios?
Do Alternative Investments Belong in Most Individuals’ Portfolios?

While proponents of alternative investments tout their diversification benefits and potential for high rewards, it’s essential to take a closer look at the bigger picture. The allure of exotic assets may be enticing, but when factoring in risks and expenses, alternative investments might not be the optimal choice for most individual investors.

Alternative investments encompass a broad category that includes tangible assets like precious metals, antiques, art, and wine, as well as financial assets like private equity, venture capital, hedge funds, and commodities. The Wall Street marketing machine has capitalized on the allure of alternatives, repackaging them into mutual funds and ETFs, targeting regular investors.

Reasons to Exercise Caution

  1. Risks: Alternative structures tend to encourage managers to take risky leveraged bets to maximize returns, often resulting in heavy losses and potential legal issues.
  2. Fees: High management fees, sales commissions, marketing costs, and leverage create significant disadvantages that can offset potential high returns.
  3. Lack of Transparency: Alternative investments often lack transparency, making it challenging for investors to fully understand related fees and risks.
  4. Lack of Liquidity: Many alternative investments lack liquidity, making it difficult for investors to access their money when needed.
  5. Higher Taxes: Alternative investments can lead to higher tax burdens due to frequent trading and a lack of control over tax management.

While some alternative investments may outperform traditional ones occasionally, consistency is challenging to achieve. Over time, the advantages of a low-cost indexed portfolio that is regularly rebalanced become increasingly apparent. Furthermore, the negatives associated with alternative investments often outweigh the potential benefits, making them an unappealing choice for many investors.

It is crucial for investors to consider their risk tolerance, financial goals, and overall investment strategy before deciding to venture into the world of alternative investments. Consulting with a trusted financial advisor can provide valuable insights and help individuals make well-informed decisions tailored to their unique circumstances.

In conclusion, the mainstreaming of alternative investments offers both opportunities and risks for individual investors. While some proponents believe in their diversification benefits and potential for higher returns, critics caution against the expenses and complexities associated with many alternative products. As with any investment decision, a cautious and informed approach is essential, taking into account personal financial goals and risk tolerance. Diversification remains a core principle in portfolio management, and whether or not alternative investments belong in most individuals’ portfolios will depend on each investor’s specific needs and circumstances.

Source: https://www.wsj.com/articles/SB10001424052702304311204579508122005330050

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