KEY TAKEAWAYS:

• Alternative assets are complex, lightly regulated, and illiquid—dangers magnified once you start living off savings.
• The classic hedge fund 2 and 20 fee structure (plus hidden expenses) drags long-term returns far below simple stock-bond blends.
• Lock-ups and valuation lags create cash-flow headaches and nasty surprises during bear markets.
• A low-cost, diversified index approach paired with strategic tax planning keeps flexibility high and lifetime costs low.

As retirement planning specialists, we work with many physicians and other high-net-worth individuals who meet the "Accredited Investor" criteria to invest in alternative asset investments. 

The wealth management industry makes a lot of money off these investment products, and financial advisors love selling these products to anyone they can. While traditionally only aimed at institutional or accredited investors, alternative investments have also begun making their way down to the retail level through mutual fund products that invest in these alternative assets.

Here’s our take on what, if any,- role alternative assets should play in a typical retiree’s portfolio.

In reality, alternative investments for retirees—private equity deals, hedge funds, collectibles, structured notes—often bring steep costs, opaque risks, and liquidity handcuffs that clash with the freedom retirement should offer.

Below you’ll see why the downsides overshadow the marketing gloss, how the fees and lock-ups actually work, and what a plain-vanilla, low-cost index portfolio can deliver instead—without sacrificing sleep or cash-flow flexibility.

What are Alternative Asset Investments?

An alternative asset is considered any investment asset that falls outside of the traditional three investment categories of stocks, bonds, or cash. Common alternative investments include:

 Private Equity/Venture Capital

Private equity and venture capital include partnerships that invest capital into private companies (i.e., not listed on a publicly-traded exchange). The investments can focus on startup and early-stage ventures to more mature companies seeking to expand or restructure.  

2. Private Debt

Private debt refers to debt investments that are not financed by banks and are not issued or traded in an open market. Partnerships that invest in private debt provide debt capital to private companies that cannot obtain sufficient traditional bank financing and lack the ability to tap public debt markets.  

3. Hedge Funds

Hedge funds are partnerships that actively manage investment pools whose managers attempt to capitalize on any number of "market opportunities." Hedge funds are unique in that they can use leverage, derivatives, and take short stock positions. Hedge funds today present a diverse group of partnerships that employ any number of investment strategies, including Long-Short, Market Neutral, Merger Arbitrage, Convertible Arbitrage, Event-Driven, Credit, Fixed-Income Arbitrage, Global Macro, Short-Only, and Quantitative.  

4. Real Estate

Real Estate partnerships can invest in any number of real estate investments, including raw land, manufactured housing, timberland, mobile home parks, farmland, apartment complexes, office buildings, retail space, and more.      

5. Commodities

Commodities represent investments in real assets such as agricultural products, oil, natural gas, and precious and industrial metals.

6. Collectibles

Collectibles include a wide range of physical objects that have the potential to appreciate in value. Collectibles can be anything anyone collects, but a few categories include stamps, coins, toys, fine art, and wine.

7. Structured Products

Structured products represent any number of pre-packaged structured finance investment strategies. Structured products come in numerous varieties of underlying assets and linked derivatives. Structured products can be complex and sometimes risky, but investment banks design them to offer investors a particular product mix to meet a particular payoff profile need. Two structured products that became infamous during the 2007-2008 financial crisis were collateralized debt obligations (CDO) and mortgage-backed securities (MBS). Investors piled into these investments when the housing market boomed before the crisis and then suffered severe losses when housing prices declined.

Why Do Individuals Consider Alternative Asset Investments?

When trying to figure a proper asset allocation for their retirement funds, many investors turn to advisors who suggest alternative asset investments as a complement to their equity and fixed income holdings.

Alternative assets are often presented to investors by advisors who personally, or whose firm, stands to benefit from their sale. Again, the wealth management industry makes a lot of money off these financial products, so they have plenty of money to employ skilled salespeople with educational credentials and offer lucrative incentives.  

The advisors' pitch usually includes some mix of the following reasons:

• Portfolio Diversification (true, but at a high cost, there are better ways)
• Exclusive Opportunity Rarely Available
• Potential for High Returns (sometimes even claiming high risk-adjusted returns; based on an improper definition of risk)

Here’s what they often fail to tell you (or tell you but quickly and briefly while highlighting only the benefits) about alternative asset investments.

3 Reasons Individual Investors Should Avoid Alternative Asset Investments

As retirement planning specialists, we believe that Individual investors in the retirement phase should avoid alternative investments based on the following three reasons:

1). Excessive Risk

The reason most alternative investment assets can only be sold to institutional investors or accredited, high-net-worth individuals is because of their complex nature, lack of regulation, and degree of risk. I would argue that, despite the strict accredited investor requirements, few accredited individual investors even have the resources or expertise (that institutional investors may have) to adequately understand and value these investments well enough to make a proper decision. 

Additionally, most alternative investments require high minimum investment amounts, only raising the stakes.  

Alternative investments usually do not have to register with the Securities and Exchange Commission like traditional mutual funds or ETFs. This lack of regulation and oversight makes alternative investments more prone to the possibility of fraud or scam. Further, private companies are under no obligation to reveal earnings, financial information, or report to shareholders, which means that information on these types of assets can be hard to find.

Another important factor to keep in mind is the risk asymmetry involved when it comes to investing in an alternative investment partnership. As we will discuss next, the manager typically gets paid annually through a management fee and receives a performance fee equal to some amount of the gains. Because of this fee structure, the manager does not really have any downside risk, which can lead to excessive risk-taking. Being more conservative only lowers the manager's potential compensation and dampens their reputation and ability to attract more capital.

2). High and Asymmetrical Cost

While it does vary, most partnerships and hedge funds are compensated on what's known as a '2/20' fee structure. A hedge fund 2/20 fee structure is composed as follows:

• 2% Management Fee - an annual fee charged by the manager to cover the operating costs of the investment vehicle.
• 20% Performance Fee - an incentive fee viewed as a reward for positive returns.

Given this fee hurdle, it is hard to see how an investor can expect to receive a return commensurate with the true risk being taken.

There are also asymmetrical incentives since managers collect annual fees even when performance is poor. This heads-I-win, tails-you-lose alignment nudges them toward levered bets. If the fund blows up, the sponsor launches a new vehicle under a new name; investors, meanwhile, absorb the loss.

3). Illiquidity

Alternative investments often have lock-up provisions that restrict an investor's ability to withdraw capital from a fund for some stated period of time. Even after this lock-up provision time, receiving cash from a sale may take 30 to 90 days. 

Further, the decision on when to liquidate is made difficult by the lack of regular pricing data. Unlike a mutual fund with end-of-day pricing or an ETF with intra-day pricing, alternative investment funds may only provide pricing data based on monthly or quarterly valuations. 

Lack of liquidity can be problematic for individual investors who are subject to possible unforeseen emergency needs for cash.

Why Alternatives Asset Investments Are Even Worse for Retirees

The issues alternative asset investments bring to individual investors are only exacerbated when approaching retirement. 

In addition to the three factors above, alternative investments are an even worse idea for retirees because they can amplify sequence of returns risk (if an illiquid fund underperforms early in retirement and you don’t have other sources of funds), and result in tax inefficiency and additional estate planning complexity (due to K-1s and/or partnership valuations for estate taxes).

When retirees need simplicity and agility, alternatives pile on complexity and rigidity.So what’s a better option for retirees?

A Traditional Index-Based Approach to Investing is Best for Retirees

Retirement is a time to lessen risk, shed excessive cost, and maximize flexibility. An investment portfolio built using low-cost index funds to build a maximally diversified portfolio of traditional investments is the best way to accomplish this goal. (see our Insight entitled "Building an Investment Portfolio for Retirement" for more).   

If you would like help constructing a portfolio for retirement, schedule a call with one of our retirement planning specialists to help you review your investments and create a retirement plan starting with our complimentary Thrive Assessment.