Should You Own Alternative Investments in Retirement?

Alternative investments come in many colors.

Man holding three colored lenses representing alternative investment choices.
Alternative investments come in a variety of colorful offerings. Make sure the color is right for you. Andy Ryan/Getty Images

Alternative investments can offer higher yields to retirees, but they aren’t for everyone. To present both the pros and cons I reached out to Joe Seetoo, Vice President, .

Morton Capital, a registered investment advisor in California, specializes in bringing hand-picked alternative investments to their high net worth clients. They receive no compensation from the underlying investments which put them in the perfect position to offer an objective opinion and do the research and due diligence that needs to be done before venturing into the alternative asset class world.

Joe and I talked through the following questions. Our views are similar; where they differ I’ve labeled answers so you can distinguish Morton’s views from my own.

What Are Alternative Investments?

Alternative investments represent assets that are not cash, stocks or bonds. Typically, they are thought of as real estate (both equity and debt), hedge funds, private equity, venture capital, commodities, private loans, reinsurance, oil and gas partnerships, and healthcare royalties.

Who Are They Appropriate For?

Morton Capital believes that most investors should have some exposure to alternative investments. The question of what types, in what form and how much depend on each client’s situation. 

For example, many alternative investments are structured for , which requires;

  1. the investor has a net worth of at least $1 million (excluding his/her primary residence), or
  2. earns $200,000 ($300,000 if married) in two of the most recent calendar years and has a reasonable expectation of maintaining the same level of income.

    Private investments are appropriate for investors who meet the accreditation requirements of the subscription and operating agreement of the investment. 

    Additionally, because these investments are inherently less liquid than the aforementioned alternatives, the client needs to ensure they carefully understand the liquidity terms of the operating agreement, their rights as a limited partner/member and what role these investments play in their larger financial plan.

      

    If a client does not meet the “accredited investor” standard, which allows them to invest in private placements, does this mean that alternative investments are not available to them? No. There are publicly traded alternative investments for which no accreditation standard is required such as gold, REITs, 1940 act hedged mutual funds and reinsurance securities that can provide some of the same benefits as private alternative investments. 

    In talking with Joe I expressed to him that my own training as a leads me to place a high premium on a certainty of outcome for retirees and thus be a little more cautious about the use of alternatives. I prefer to have a core portfolio of non-alternatives in place before adding alternatives, and I think alternatives are best suited for the high net worth investor.

    Joe explained that alternatives offer a different form of risk/return trade-off. You give up liquidity in return for what Morton believes will be a higher return in the long run - what is described as an "illiquidity premium".  Morton views this illiquidity premium as adding certainty to the long-term outcome. Ultimately their goal is the same as mine - adding certainty to a client's outcome.

    We also discussed the mutual concern of alternatives being sold by rogue "advisors" who receive high commissions on the alternatives they recommend and don't do the needed due diligence and analysis that needs to be done before investing in this market. Joe and I both agree you need to do your homework on the person recommending the investment. As I mentioned, Morton Capital isn't compensated by the underlying investment -  they represent their clients - not the investment itself.

    And overall, if you don't understand the investment, don't buy it. That goes for any investment, not just alternatives.

    Where Do You Buy Them?

    Certain alternative investments are publicly traded in the form of mutual funds and/or exchange-traded funds. Many of these are available through brokerage firms or from the sponsor directly.

     

    With regard to private alternative investments, sourcing potential investment products is a challenging task. Large financial institutions like BlackRock and J.P. Morgan will sponsor private funds, which are limited to accredited and qualified prospects.  Beyond these household names, there is a multitude of smaller sponsors that create and manage their own funds. 

    Unlike stocks and mutual funds, where information is readily available, finding appropriate alternative investments requires a large time commitment on behalf of the investor to identify, screen and conduct proper due diligence.         

    Why Would You Own Them?

    In Morton Capital’s opinion, there are several reasons to own alternative investments:

    • Higher levels of income – With interest rates at historic lows, many investors who are seeking income are forced to extend maturities or buy lower quality “junk bonds” in order to generate sufficient cash flow to fund their retirement.  There are a variety of other investments beyond bonds and high dividend stocks that provide cash flow.  Some examples include reinsurance securities, real estate, healthcare royalties and first trust deed partnerships. 
    • Risk substitution – When building a portfolio, we look at sources of risk.  One risk factor that is commonly overlooked and misunderstood is illiquidity.  In our opinion, investors who focus solely on a traditional portfolio, which typically has a very high degree of liquidity (stocks and bonds), are essentially paying a cost for the psychological security. This form of payment is manifested in the form of lower expected returns (all other things being equal). It is rare that a client needs to liquidate 100% of his portfolio on a given day. In fact, the industry is always saying “invest for the long term.” By allocating a portion of your portfolio to investments that are not liquid on a daily basis, we are taking on some level of illiquidity risk and we are removing risk from the other “buckets” like interest rate risk and price risk (stock market volatility). By having different risk factors in the portfolio, we have created a more diversified portfolio. Additionally, we believe that we can earn a premium to what is available in the public markets by taking on a certain level of illiquidity (“illiquidity premium”).        
    • Uncorrelated returns – One consequence of the 2008 financial crisis that we saw was the significant rise in correlation among financial assets as contagion risk spread globally. While real estate and hedge fund managers were hit, many talented alternative managers fared much better during this tremendously difficult time. Additionally, certain other alternative investments like real estate, reinsurance securities, gold and royalties managed to perform reasonably well.  
    • Better downside protection – Historically, bonds have done an excellent job of cushioning the decline in the equity markets. However, with interest rates at all-time lows, we believe their efficacy will be muted. For example, in 2015, many global stock markets were negative and yet the Barclay’s U.S. Aggregate only managed to gain 0.6%. Furthermore, certain credit sectors and junk bonds lost money as spreads widened out. There just isn’t much room left for rates to compress and push up returns on bonds if we continue to get a sell-off in riskier assets.  We believe that certain alternative investments can replace traditional bonds to protect against downside moves in the equity markets.        

    I asked Joe about the better downside protection of alternatives. Certainly, they are correct - in a rising interest rate environment, you can expect bond values to go down. Yet there are ways to own bonds that insulate you from the effects of rising rates.

    For example, if you buy a bond that you are planning to own to maturity, a process called asset-liability matching, then you know what you will get when the bond matures and the interim price movements will not affect your outcome. Joe agreed, asset-liability matching does offer excellent downside protection, albeit often with a low return. Where alternatives can play a role is as an option to a more traditional portfolio of bond funds where the bonds aren't earmarked for specific spending needs in a future year.

    How Much of Your Portfolio Should You Allocate to Alternatives

    Morton believes there is no standard rule of thumb as to how much you should allocate to alternative investments. Clearly, each client’s financial plan and investment objectives will dictate to what degree alternatives make sense.

    Generally speaking, one of the primary concerns that need to be addressed is illiquidity risk for private investments. To what degree, does the client have enough liquidity in other assets to allow them to achieve their financial goals? With that said, it is not uncommon for many of our clients with more than $5 million of investible assets to have 50% of their portfolio in alternative investments.  It is also important to remember that some of these alternatives are liquid on a daily or quarterly basis (i.e., 1940 act mutual funds and exchange-traded funds).  

    For clients who have not previously invested in alternative investments, we would recommend starting with a small allocation (5-10%) and dip your toe in the water before making a huge commitment.

    I agree completely with Joe that each client’s financial plan is the determining factor in what investments are recommended. For those in retirement, I am comfortable allocating to alternatives to the degree to which those assets are not required to make the plan work. Meaning if you can afford to take the risk, then this asset class can be appropriate – but there is no free lunch.

    You don’t partake of higher returns without a trade-off of some kind. That trade-off in terms of liquidity was explained above. I also respect Morton's view that higher potential returns from alternatives can help make the plan work. Morton has years of experience with this asset class that gives them confidence in the outcome. 

    What Types of Alternatives Should You Stay Away From?

    Morton’s expertise is doing due diligence on alternatives. Some of the key factors they consider when looking at private alternative investments are:

    1. Conflicts of interest – Do the key decision makers have potential conflicts of interest or are their interests aligned with our clients?     
    2. Transparency – Are we able to get information from the general partner in a timely manner and do they provide us access to information in order to conduct proper due diligence?
    3. Structure – Does the partnership have the proper organizational structure and controls to make us feel comfortable (i.e., cash controls, independent auditor, legal counsel, administrator, depth of their team)?
    4. “Skin in the game” – Does the general partner have a significant amount of their personal net worth invested in the strategy they manage?  If not, we generally will not invest in their strategy.

    Another major consideration for investors in retirement involves the custodian, since IRA accounts are typically part of most clients’ financial plans. All assets held in an IRA need to be registered with a qualified custodian. This can present unique challenges for private partnerships, which will need to be vetted by the custodian before they can be registered on their platform. Some self-directed custodial platforms don’t require the investments go through a vetting process but these custodians may charge high administrative fees to custody this unique asset. Investors should carefully consider these issues and costs when making their decision. 

    Dana Anspach

    I would add that another additional factor to consider is taxes. For many high income, high net worth folks, the after-tax yield on an investment that produces a 9% income stream is 4 – 5%. When comparing the risk-return trade-off on various investment options look at after-tax results.

    And look at the level of certainty behind the income stream. You don't want to be in a position of relying solely on the income stream off alternatives. I watched the income stream on many alternatives dry up in 2008/2009. At the same time, dividends on stock went through a substantial decline. As you venture into alternatives, make sure you have a balanced plan so that you have emergency reserves/liquid assets to offset your less liquid ones.

    Overall, I agree with Morton, alternatives can be a good addition to a portfolio, particularly for high net worth folks, if you have the right firm doing the research for you.