Why should advisors include alternative investments in their clients’ portfolios?  Diversification, diversification, diversification. Like location in real estate, diversification seems to be the key factor for including alternatives in a portfolio. It’s not quite as simple as that, of course, but there is no doubt that diversification is one of the chief reasons cited for allocating a portion of a portfolio to alternative investments. What percentage of a portfolio should be allocated to alternatives, for this purpose (or any other) is another issue, and each advisor will have their own opinions. We take a look at what allocations looked like in 2021 and what they might look like going forward.

A chart of fluctuating values

Once regarded with skepticism, or at least wariness, by some advisors, alternatives have been mainstream for a considerable time now. Still, portfolio allocations only average a little over 10 percent. The benefits of alternatives are widely recognized, not only for diversification and downside protection, but also for the potential for higher returns; yet many advisors still weight their clients’ investments strongly towards traditional stocks, bonds and equities. While 83 percent of advisors apparently agree, or somewhat agree, with the benefits of alternatives, they are not, apparently, willing to increase the proportion of their allocation. That said, the Cerulli Associates/Blue Vault Partners white paper referenced below finds that 19 percent of advisors increased their allocation of alternatives in 2021 as a result of the pandemic, with 10 percent increasing their exposure to private debt. In the current climate of low interest rates, generating income from traditional investments is becoming increasingly challenging, making the case for alternatives stronger still; one wonders, therefore, why many advisors only anticipate raising their allocation by 1 or 2 percent in the next few years? 

Blackrock recognizes four pillars that make alternatives attractive to investors and advisors alike, stating their purpose within a portfolio being to: hedge, diversify, modify, and amplify. The first three of these pillars are concerned with risk reduction, while amplification is concerned with enhancing returns and income. Approximately 25 percent of advisors want to enhance returns and are consequently looking for amplification; however, the majority of advisors are looking at risk reduction and are thus seeking diversification – the clear favorite of the three pillars for risk reduction.

“Diversifiers are an efficient way to lower risk by adding unique portfolio exposures. Hedges and modifiers, while helpful in some contexts, can be ineffective, costly or both.” Blackrock, December 31, 2020.

Perceived drawbacks to greater allocations of alternatives are illiquidity and complexity. Illiquid investments, which include most real estate, make them less suitable for clients requiring access to their money at short notice; similarly, the high management fees and complexity of certain investments, which make it challenging for advisors to carry out due diligence, are also apparent factors in their reluctance to allocate higher proportions of clients’ portfolios to such vehicles. Enhanced liquidity would likely make many alternative investments more attractive to advisors. According to a white paper published by Cerulli Associates and Blue Vault Partners in September 2021, 70 percent of firms encourage allocation of select alternatives, with 21 percent encouraging broader use and just 10 percent discouraging them.

An excerpt from an investment text

Interestingly, client requests for the inclusion of alternative investments in their portfolios are cited as a driving factor for around 21 percent of advisors.

However, Blackstone Real Estate Income Trust (BREIT) recommends investment in stable, income-generating commercial real estate across what it considers to be five key property types: residential, industrial, hotels, retail, and office buildings. The potential for both capital growth and high returns in commercial real estate makes these alternatives attractive to investors, despite illiquidity concerns.

Barron’s also takes a more optimistic outlook:

“Stocks, bonds, and cash, the three traditional pillars of an investment portfolio, are looking a little wobbly lately. Inflation-adjusted yields on cash are negative. Bonds are being squashed by interest-rate fears. And stocks are historically expensive. To meet investors’ needs, financial advisors are increasingly turning to alternative investments such as real estate and private equity.” Barron’s Steve Garmhausen, October 27, 2021.

The Barron’s article quotes various advisors with a more positive view to the allocation of alternative investments:

  • Angie Spielman, financial advisor for Manhattan West, supports a starting point of one third each for fixed income, equities, and alternatives – a considerably higher allocation of alternatives than reported in other surveys.
  • Eli Cohen, head of alternative investments for GenTrust, states that his firm’s allocation of alternatives rises in sync with a client’s size and capacity to take on illiquid exposure. For those looking at long-term investment, illiquidity is obviously less of a deterrent.
  • Aaron Rottenstein, advisor for UBS, says: 

“When clients can handle the illiquidity, we’re gravitating toward alternatives, and especially private real estate and private equity, even for clients who have been resistant to alternatives in the past.”

Therefore, we can deduce that there is a more positive view towards alternatives out there, and it is driven, at least to some extent, by client demand. Liquidity and complexity continue to be seen as drawbacks; however, it is becoming increasingly difficult to justify the reluctance of some advisors to increase their allocations of alternatives, particularly when we consider the high rates of returns available in some such investments. 

Perhaps the traditional portfolio allocation of stocks and bonds worked well for so long that advisors have been slow to see any reason to change a proven formula. However, diversification can mitigate the volatility of the stock market and, while there are never guarantees on returns, alternative investments definitely have the potential to outdo traditional investments in this respect. Alternatives have always had a following with high-net-worth investors, but institutional investors are now turning to alternatives in greater numbers, while REITs and mutual funds can help make investing in alternatives more accessible to individual investors also. We can only hope to see increased allocations of alternatives going forward.