By Michael “Mick” Pepper, Senior Vice President – Investments Senior PIM® Portfolio Manager at Virtuent Wealth Management Group of Wells Fargo Advisors
Alternative investments continue to gain popularity among high-net-worth investors. The Wells Fargo Investment Institute (WFII) estimates that private capital investments have soared from $1 trillion in 2003 to over $15 trillion in 2023, leaving many qualified investors wondering if this asset class is right for them. Diversification and the potential for lower volatility and higher returns may improve portfolio outcomes, offering a compelling case for consideration. But what exactly are we talking about when we say, “Alternative Investments”?
What are Alternative Investments?
Alternative Investments, or “Alts,” refer to investments in asset classes that fall outside traditional stocks, bonds, and cash alternatives. These include Private Equity, Private Credit, Private Real Estate, and Hedge Funds. High-net-worth investors often consider Alts to add a non-correlated source of returns to their portfolio, aiming for increased diversification and potentially enhanced performance.
Alternative Investments & Portfolio Risk/Return
Historical data supports the idea that incorporating alternative investments can enhance a portfolio’s risk/return profile. According to JPMorgan Asset Management, portfolios that include a mix of equities, bonds, and alternative investments tend to exhibit lower annualized volatility and higher returns than those with a traditional stock/bond allocation.
Specifically, a portfolio balanced with alternatives, equities, and bonds demonstrates superior performance metrics, showcasing the benefits of diversification through reduced volatility and improved risk-adjusted returns.
The Power and Benefits of Private Markets
While investors often focus on the stock market, it is important to note that the combined value of all companies listed on the New York Stock Exchange represents only a tiny fraction of U.S. businesses, with the vast majority being private companies (Source: Stepstone). Private markets offer greater opportunities due to the larger number of companies available for investment. According to Ernst and Young, there are approximately 16,000 private equity-backed companies compared to 4,000 public companies. These companies often present a higher risk/reward profile and can offer diversified returns. Additionally, private credit, including senior secured loans and direct lending, can provide higher income streams and returns than traditional bonds, offering lower correlation and decreased volatility (Source: Wells Fargo Investment Institute).
Investment and Insurance Products: Not FDIC Insured / No Bank Guarantee / May Lose Value
Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC, Member SIPC, a registered broker-dealerand non-bank affiliate of Wells Fargo & Company PM-12272025-6744324.1.1Private capital, encompassing private equity and private debt, opens up investment opportunities beyond public markets. Private equity investments can fund new technologies, expand working capital, and facilitate acquisitions, whereas private debt can offer senior-secured and mezzanine debt options. These investments often benefit from the lack of public information, allowing investors to exploit pricing inefficiencies and engage in hands-on corporate change (Source: Wells Fargo Investment Institute).
Items for Consideration
• Liquidity: Accessing funds is crucial when evaluating alternative investments. The typical term for traditional private equity funds is lengthy. However, recent innovations have led to new strategies designed for easier access and liquidity via semi-liquid products. These can offer greater accessibility, including periodic liquidity and immediate capital deployment, as opposed to the more restrictive private investments of the past.
• Leverage: Some alternatives, like hedge funds, employ leverage to enhance returns, which can enhance returns, albeit with increased risk/reward profiles.
• Value Add: The value add for alternative investment managers can vary but may include targeted increases in income, enhanced returns, potential tax advantages and steady cash flow in private real estate, and significant growth in diversified and under-explored markets in private equity. The main goal is often to reduce correlation to traditional markets and dampen volatility while enhancing overall portfolio returns.
Accessing Alternative Strategies
To invest in Alts in their original form, one must qualify as an “accredited investor” or a “qualified purchaser.” The Securities and Exchange Commission defines an accredited investor as an individual or entity with a net worth exceeding $1 million and income over $200,000 in the past two years. A qualified purchaser must meet a higher threshold: individuals need $5 million in investable assets, and institutions must have over $25 million.
However, alternative investment strategies are no longer restricted to institutional investors. With the advent of alternative mutual funds, a broader range of investors can access these strategies. These funds aim to employ similar strategies as hedge funds, including short selling, leverage, and derivatives, while offering the benefits of daily liquidity and more straightforward tax reporting.
Conclusion
Alternative investments offer high-net-worth investors the opportunity to expand their investable universe into private markets, increasing diversification through non-correlated asset classes and potentially enhancing value to meet their wealth goals. Advances in technology have created new opportunities and entry points for accredited investors via semi-liquid interval funds and through more liquid alternative mutual funds, easing tax reporting and enabling immediate cash deployment. Alternatives should be considered an important component of long-term strategic asset allocations, helping improve investors’ risk and return experiences and increasing the probability of achieving financial goals.
For more in-depth discussions on the pros and cons of alternative investments, please contact Mick Pepper with the Virtuent Wealth Management Group of Wells Fargo Advisors at [email protected]
Alternative investments, such as hedge funds, funds of hedge funds, managed futures, private capital, real assets and real estate funds, are not appropriate for all investors. They are speculative, highly illiquid, and are designed for long-term investment, and not as trading vehicle. These funds carry specific investor qualifications which can include high income and net-worth requirements as well as relatively high investment minimums. The high expenses associated with alternative investments must be offset by trading profits and other income which may not be realized. Unlike mutual funds, alternative investments are not subject to some of the regulations designed to protect investors and are not required to provide the same level of disclosure as would be received from a mutual fund. They trade in diverse complex strategies that are affected in different ways and at different times by changing market conditions. Strategies may, at times, be out of market favor for considerable periods with adverse consequences for the fund and the investor. An investment in these funds involve the risks inherent in an investment in securities and can include losses associated with speculative investment practices, including hedging and leveraging through derivatives, such as futures, options, swaps, short selling, investments in non-U.S. securities, “junk” bonds and illiquid investments. The use of leverage in a portfolio varies by strategy. Leverage can significantly increase return potential but create greater risk of loss. At times, a fund may be unable to sell certain of its illiquid investments without a substantial drop in price, if at all. Other risks can include those associated with potential lack of diversification, restrictions on transferring interests, no available secondary market, complex tax structures, delays in tax reporting, valuation of securities and pricing. An investment in a fund of funds carries additional risks including asset-based fees and expenses at the fund level and indirect fees, expenses and asset-based compensation of investment funds in which these funds invest. An investor should review the private placement memorandum, subscription agreement and other related offering materials for complete information regarding terms, including all applicable fees, as well as the specific risks associated with a fund before investing.
