|Why Alternative Investing and What Is an Alternative?
Focus on using what your clients have to help them get what they want out of life, though it may involve thinking outside of the boxes and stars.
August 18, 2011
Beyond the three primary liquid asset classes — equities, fixed income and cash — many other types of investment classes can be used to diversify your client’s investment portfolio and help smooth out the portfolio’s volatility. The key is to create real negative correlation within their portfolio help reduce risk, while increasing the targeted return.
Retail advisors use the term "alternative assets" to describe investments that they do not receive a commission, such as natural resources, gold, precious metals, art, antiques, jewelry, collectibles and financial futures. Your stockbroker won’t recommend you buy real estate, just as your real estate agent won’t recommend you buy stocks. This leaves a number of clients with the wrong type of long-term investment portfolios.
Most clients do not understand that there is a premium to be paid in the form of lower long-term real rates of return for constant liquidity. Your clients are giving up the real opportunity to purchase assets that truly respond differently as they are supposed to.
Retail advisors have told their clients these assets are way too risky. But to truly understand the inherent illiquidity risk, you must understand what the underlying investment is really designed to do. Two sources from which most successful investors get their non-correlated income streams are private ventures and income-producing real estate, both of which involve the use of positive leverage on self-amortizing assets.
Just as business owners use their company’s assets to both create income streams and to force equity growth within their companies, your clients need to learn how to use these alternative asset classes to meet certain investment characteristics within their own portfolios beyond instant liquidity. Your clients are not associating volatility with risk, since volatility is nothing more than temporary pricing adjustments, which over the long-term tend to re-adjust to their targeted mean rates of return across all asset classes.
The problem most clients have with alternative assets is that they must actually do their own due diligence before making a decision. They normally do not have the knowledge or access to the unique investing strategies to turn real assets into cash-flows. For many clients their advisors and their investments are not being aligned to meet their long-term individual goals and objectives, nor is their advisor looking at their personal net worth as a total balance-sheet approach to helping them replace cash flows for retirement and funding their consumption driven goals by using both side of the their personal balance sheet — assets and liabilities.
Key Reasons to Invest in Alternative Asset Classes
Here are three key reasons why your clients should consider investing in alternative assets:
The alternative asset classes’ performance is often highly dependent on the qualities of the underlying asset and is not highly correlated to the overall economy or general stock market. For example with real estate, local conditions, cash-flow and location all dictate the future value of the assets. Regardless of what the stock markets are currently doing, your clients will continue to receive uncorrelated (to the stock market) income payments in the form of monthly rental checks.
However, diversification alone cannot guarantee that your investment will make a profit or ensure against a permanent market loss. While alternative assets offer the potential for targeted returns that aren't as highly correlated with other liquid markets, their unique properties also mean that they can involve a high degree of risk on a stand-alone basis, if you do not create the right type of targeted portfolio by blending all of the asset classes to meet specific known income amounts and rates of return. These alternative assets can be utilized to produce specific attributes within your client’s portfolio that can not be obtained with only the three liquid asset classes.
Tradeoffs to Owning Alternative Assets
Liquidity. Finding a willing buyer may be difficult when your client is ready to sell their asset. This is no different than trying to sell a practice or a home in a down market. This illiquidity provides the opportunity for better returns if sold at the right time. By being in these less liquid investments, it forces your clients to not jump in and out of their investments on a daily basis due to the higher transactional costs, thus helping them to stay the course and focus on their long-term goals.
Difficult to measure and model. The performance of alternative assets can be challenging to research, price and actually understanding how to run it like a business. Knowing how much to pay for it and how to finance it and knowing how long to hold it and how to exit it are all key factors that are needed to optimize the return of any investment, so unless your clients have a knowledgeable advisor, they are going to have to learn this information on their own.
Access. Your clients may not be permitted to invest in certain types of investment vehicles if they do not meet suitability requirements for investing, such as income levels and minimum investment requirements. Unless you educate them to run it like a business, most banks are not going to take them seriously. They want to see an entry and an exit strategy for the investment to make sure that your clients are going to have positive cash-flows before they will feel comfortable lending money to them.
Because alternative assets are subject to less liquidity, without the right type of asset allocation and business structures in place to counter balance the individual risks, some clients may become too heavily invested in one type of illiquid investment, (i.e., their business). You as their advisor want to make sure that they do not have all of their cash tied up in only a few illiquid investments.
Your clients need your help to develop liquidity options. They need your help to develop non-correlated income streams and create strategies to protect the downside risks within their total financial lives. Now is the time to help them utilize their high-documented incomes, growing tax burden and peak credit scores to help them build an investment portfolio that utilizes their total net worth to help them fund their dreams and goals.
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Michael J. Fitzgerald, CPA, PFS, CFP, MST, is president and founder of Houston, Texas-based Fitzgerald Financial Partners, LLC, a “Fee-Only” wealth management and investment advisory firm in. You can reach him at 713-623-1353. Investors should always consult their tax, legal and investment advisor before implementing any new investment strategy or asset allocation.
* The AICPA’s PFP Section provides information, tools, advocacy and guidance to CPAs who specialize in providing tax, retirement, estate, risk management and investment advice to individuals and their closely held entities. All members of the AICPA are eligible to join the PFP section. For CPAs who want to demonstrate their expertise in this subject matter apply to become a PFS Credential holder.
* * DISCLOSURE: Readers should assume that all insurance advice mentioned in this column are the author’s and/or his firm’s unless otherwise noted and does not necessarily reflect the views of the AICPA or the AICPA Wealth Management Insider.