Wealth Planning Insights
Tanglewood’s Thoughts on “Alternative Investments”
Brian Merrill, CFP®, July 2024
“Should I be investing in ‘alternative investment’ funds?” “If so, then what is Tanglewood’s potential role in that process?” Several clients have posed such questions to us recently. I will address them after giving a brief history of alternative investments.
Alternative Investments Over the Years. Over my 22-year investment career, different strategies of “alternative investments” have been “hot”. Perhaps you remember them.
In the early 2000s it was Venture Capital (VC). They raised money to get in early on the next Dot Com mega success. Then we had the tech crash, poor returns, and VCs fell out of favor.
In the mid-2000s, it was Private Real Estate which ended poorly during the Global Financial Crisis (GFC).
Hedge Funds gained prominence during the GFC for their exceptional returns when other asset classes fell. This fostered a scramble for these funds as many investors were convinced it should be a permanent holding to hedge risk in their portfolios.
What worked spectacularly in the GFC did not work nearly so well for investors in the following years when markets rose sharply. With some notable exceptions, those hedged investments became anchors on investors’ returns.
As the bull market continued, Private Equity and Private Real Estate took over as the most popular alternative investments. These investments took advantage of the cheap money available because of the Federal Reserve’s zero interest rate policy. This “leveraging” worked remarkably well so long as the underlying asset values went up and interest rates remained low.
But now the attractive environment that Private Equity and Private Real Estate took advantage of is reversing. With interest rates spiking over the last couple of years, the cost of their leverage has increased dramatically and the multiples on exit are smaller than expected.
The most recent “must have” alternative investment category is Private Credit (private loans). The big hurdle here is taxation.
Unlike pensions and endowments, the traditional investors in alternative investments, high net worth investors pay income tax. As the return is ordinary income, investors end up giving a significant portion of the return to Uncle Sam.
Should I be Investing in Alternative Investment Funds? We believe that your “safe capital” (see page 8) should be sufficient before considering alternative investments. Also, the history of private investments makes us more than a little cautious about recommending such investments as they tend to run hot and cold and are not liquid.
Of course, there are outstanding private investments. However, finding them requires a great deal more due diligence because of the opaqueness of their regulatory filings, potential leverage and lack of liquidity.
At the end of the day, the decision should be almost exclusively based on the specific investment and the investment manager (sponsor’s team) that employs the investment strategy.
Proper due diligence should focus on prior performance and how they achieved that track record. Other important factors that will play in that decision are fees, other costs, level of leverage, liquidity, and correlation with other investments.
There is certainly a place for private investments in some high net worth investor portfolios. They can provide some added level of diversification through access to opportunities that are not available in the public stock or bond markets.
These are some considerations for those interested in looking further:
It should not alter your lifestyle if you lose the entire sum invested.
Make sure you are working with a knowledgeable professional with a verifiable track record.
Ideally, you will outlive the investment. These investments can be a nightmare in an estate settlement.
Be prepared for the extra paperwork and filing at tax time.
You should have the time and “bandwidth” to follow your alternative investments.
You should consider special industry or regional knowledge that complements this investment.
What is Tanglewood’s Role? Until recently, most alternative investment companies were only open to pensions, endowments and insurance companies. Over the last five years almost all of the major alternative investment companies have created “Private Wealth Solutions” (PWS) groups to work with wealth advisors like Tanglewood.
PWS groups did two things that made investing more palatable for individuals. First, their new offerings have been designed to be somewhat more liquid than traditional private funds. Second, they qualified them to be acceptable to platforms like Schwab.
The final hurdle for them was administrative. Knowing the subscription system and the number of K-1s would face some resistance from individual investors, systems were developed to mitigate some of the tax and paperwork issues.
Given the ever evolving alternative investment world, we have almost unlimited options for what we can invest in, and the ways that we can invest in them. We intend to explore this further with interested Wealth Management clients this fall.