Private Wealth Managers: Master the Alternative Investments Learning Curve

Currently, just 5 percent of assets under management in alternative investments are held by individual investors, according to a 2023 Bain & Company report on private equity. The majority of advisors believe that alternative investing allows advisors to differentiate their practices from their competitors, attract high-net-worth clients and consolidate and retain assets under management, according to a report by Cerulli Associates, Invesco and the Investment & Wealth Institute. Yet half of the advisors surveyed by Cerulli reported an alternative allocation of 5 percent or less even though the surveyed group overall said that 13.3 percent was the optimal alternative asset allocation.

What could encourage wealth managers to suggest their private wealth clients increase their allocations to alternative investments?

The benefits

The reasons for a wealth manager to offer alternative investments to their clients are compelling both from portfolio construction and practice management perspectives. Where alternative investments would be appropriate, based on a client’s risk tolerance and time horizon, options such as private equity and private real estate can provide a diversification benefit and enhance the portfolio’s risk-and-return profile.

Being able to credibly offer alternative investments may require transformation of a firm's wealth-management practice. Driven by continued growth of the capital markets, the generational transfer of wealth and substantial liquidity events, such as the sale of a business, wealth-management firms are advising larger client accounts than ever before. This has created a heightened level of competition and many firms have responded by expanding their staff and the services they can offer to clients. Providing access to sophisticated alternative investments was at the top of the list of many firms when they decided to expand their service offerings. While only five years ago clients viewed the ability to allocate to alternative investments as a significant differentiator for a practice, they now see it as a requirement.

The practice-management impact of possessing a sophisticated alternative investment capability is far reaching. The ability to help a client build a successful alternatives program provides validation to the approach and can allow for that relationship to grow and produce client referrals. Most important, a firm with this capability can market these services and compete for additional business that requires a robust alternatives capability. In most cases, clients seeking alternatives expertise have a larger asset base, therefore developing the ability to engage these types of relationships will position many firms to grow their assets substantially.

The challenges

Alternatives education

Advisor education is a topic that gets discussed as part of the use of alternatives, however its importance gets overlooked. Due to the complexity of alternatives, many experienced advisors are not as conversant in this space, which can bring any discussion on the topic to a grinding halt.

The reality is as important as it is clear: Advisors who do not feel confident and knowledgeable about investing in alternatives will not raise the topic with their clients. While advising on alternative investments may not be warranted for all wealth management firms, for the many where it is important, a dispassionate assessment of knowledge across their advisors is a critical first step. Wealth-management firms must implement a comprehensive educational process to help ensure their advisors are comfortable with the asset classes, unique characteristics and operating rhythm of alternative investments. Only then will a firm be prepared to credibly engage clients on this important topic.

Furthermore, clients new to the alternative asset classes also have a learning curve before they can comfortably invest in this space. Understanding concepts such as the J-curve and capital calls is vital for investors, as well as the impact many of these investments will have on the timing of their annual tax filing. Setting and managing client expectations cannot be overemphasized on this topic, as it can vary substantially from the traditional investment world.

Due diligence

The importance of comprehensive due diligence for alternatives cannot be overstated due to the opaqueness and complexity of many strategies. For most advisors experienced with the traditional asset classes, evaluating the alternatives universe presents unique challenges. Importantly, the due-diligence process is designed for the dual purpose of identifying the potential risks and advantages of a strategy, along with understanding if there is a differentiated approach that could outperform versus peers.

Operational due diligence is especially important for alternatives and requires an experienced person to fully understand the back-office aspects of an asset manager that differ from the evaluation of a traditional firm.

The performance dispersion between the top- and bottom-quartile managers in alternatives is wider than in the traditional asset classes, which underlines the importance of using a process aimed at finding the top strategies available for investors. As a greater number of alternatives asset managers make their services available to private wealth advisors, take a cautious approach to ensure that only institutional-quality strategies are presented to investors. The allure of investing in “institutional” alternatives should not allow any advisor to conflate access with quality.

Sources of alternative investment research

The true challenge is created by a great opportunity: A new client opportunity with an existing allocation to many alternative investment strategies. Among the first questions the client will ask the advisor is how to evaluate the existing portfolio and determine how to proceed. Being asked that question is a very positive sign about the caliber of client an advisory practice is attracting. The answer can be difficult unless the wealth manager has access to an experienced team that knows many managers across the industry. Each firm needs to consider what type of resources need to be in place so they can answer with confidence.

Private wealth firms need alternatives expertise

From our perspective, data and information have never been more plentiful about alternative investments, yet there continues to be a lack of insight for many wealth management firms. Sifting through the plentiful information available does not get advisors closer to fulfilling their fiduciary obligations and arriving at appropriate recommendations.

The insight needed can only be provided by experienced researchers in alternative investments and each firm needs to decide how best to source that expertise for their practice. While the learning curve can be steep for many advisors, the ability to provide more robust solutions for some clients and elevate their practice is worth the investment of time and resources.

We are still in the early days of significant industry change; however, this movement is inevitable and will continue to gain ground and advocates as more firms realize the potential benefits.