For decades, wealth managers constructed client portfolios using a mix of stocks and bonds weighted by risk tolerance. A basic 60/40 allocation provided the foundation for countless financial plans. But the world has changed.
This once-reliable asset allocation now struggles on two fronts:
- Low bond yields offer inadequate diversification and income. With Treasuries yielding under 3%, the fixed income side of portfolios cannot deliver the ballast it once did against stock volatility, nor the consistent income many clients seek. The math no longer adds up.
- Stocks are increasingly volatile and overvalued by historical metrics. Equities face overvaluation headwinds, with the S&P 500 trading at 22X earnings versus a 15X historical average. Meanwhile, retail investors piling into passive index funds exacerbate volatility as money sloshes indiscriminately.
In short, the 60/40 construct lacks the return and risk management firepower it possessed historically. Clients need more diversified approaches.
Persistently low bond yields have also created dilemmas for clients relying on portfolios to generate retirement income:
- Retirees struggle to organically generate the income they need from paltry fixed-income returns below 3% on safer bonds. It forces greater reliance on selling down the principal.
- This drawdown effect means retirees burn through portfolio value faster in a low-rate environment. Sequence risk – poor returns early in retirement – undermines sustainability.
The bottom line is traditional asset allocation models built on 60/40 no longer deliver the results they once did. Wealth managers need access to more diverse asset classes.
Of course, not all wealth managers may have the ability to incorporate alternatives depending on their licensing and broker-dealer relationships.
Registered investment advisors with greater flexibility in securities recommendations will find it easiest to adopt an allocation. But even for more restricted wealth managers, this guide can provide valuable perspective on where the industry is headed.
For those able to implement, embracing alternatives can provide a competitive advantage in attracting clients and adding value. But regardless of current constraints, all forward-thinking wealth managers should educate themselves on how alternatives may play a greater role in optimal portfolio construction going forward.
The solution lies in embracing alternatives to construct truly diversified portfolios. Alts from private equity to real estate help manage risk while unlocking higher return potential.
Wealth management platforms now provide access to institutional quality alternative investments once restricted to pensions, endowments, and family offices. But you must perform diligence just as you would traditional securities.
Historically, private equity’s double-digit average returns came through huge minimums and multi-year lockups. Now expanded access opens the door for clients to capitalize on the illiquidity premium these investments offer:
- Democratization expands access beyond institutions. Platforms enable investing in PE funds with as little as $10K through feeder vehicles. Clients can build diversified PE allocations.
- Illiquidity premium boosts return potential. The need to tie up capital has rewarded patient PE investors with returns exceeding public markets by about 3% on average. The excess compensates for added risk.
PE also provides a low correlation to stocks and bonds. But ensure clients are comfortable with 5-10-year time horizons.
Real estate investments through platforms provide exposure to physical assets with intrinsic worth:
- Physical assets provide an inflation hedge as living and construction costs rise. Property values and rent cash flows tend to keep pace over time, providing a hedge.
- Cash-flowing rentals generate monthly income. Beyond appreciation, income-producing properties deliver consistent dividends that can supplement portfolios.
The natural diversification from housing and commercial real estate enhances portfolios not overexposed to financial assets.
Peer-to-peer lending platforms enable investors to fund loans receiving 6-10% yields based on credit risk models:
- Earn 6-10% fixed income lending to consumers and SMEs. Returns consistently exceed high-yield bond yields through streamlined operations.
- Shorter 3-5-year terms increase flexibility vs traditional bond ladders. Investors aren’t locked into longer maturities when rates rise.
P2P loans provide monthly cash flow from underlying interest, while short durations limit interest rate sensitivity.
Equity crowdfunding opens private startup investing to clients seeking higher growth:
- Venture capital-like returns from early-stage companies before they IPO or sell. Top performers can generate outsized returns while diversifying beyond public markets.
- Gain exposure to disruptive startups reshaping industries from space to biotech to fintech. Invest in what interests clients.
Let clients tap into the 85% of venture returns historically generated from the top 10% of deals through broad crowdfunding deal access.
Deciding which alternative investments to incorporate is only half the battle. You must carefully build out the allocation, select platforms, vet deals, and communicate with clients.
When first venturing into alternatives, moderation is key:
- Start small at 5-10% to test the approach, build confidence and experience, and limit risk.
- Limit individual alternative asset classes to 1-3% for diversity. For instance, devote 1% each to P2P loans, real estate, PE secondaries, and crowdfunding.
As you gain experience and conviction, gradually increase allocations while maintaining balance. Re-assess and rebalance just as with traditional assets.
Thoroughly vet platforms providing access to alternatives as you would a traditional custodian:
- Select based on asset class breadth, track record, fee transparency, investment minimums, reporting capabilities, and integrations with portfolio accounting systems.
- Look for established players with solid institutional backing and deal flow. Avoid fly-by-night platforms.
The right platform provides quality access to deals your clients couldn’t find themselves with robust reporting.
While platforms conduct diligence, you still must vet individual deals just as if evaluating a stock or bond:
- Rigorously scrutinize deal sponsors, business models, financials, use of funds, risks, and exit strategies as you would an equity research report. Lean on platform due diligence but verify.
- For real estate, stress test occupancy projections and capital plans. Analyze deals as if you were the landlord.
- For lending, dig into borrower credit models and historical loss rates. Kick the tires on risk ratings.
Alternatives must clear the same bar as traditional investments in your selection process. Never compromise diligence.
Set proper client expectations by emphasizing the nuances of alternatives:
- Stress higher volatility and illiquidity tradeoffs against return upside. Avoid surprises down the road.
- Report performance consistently using rigorous valuation methods. Strive for transparency akin to traditional assets.
- Compare alternative performance to appropriate benchmarks like PE indexes as you would bond vs. Treasury yields.
Thoughtful communication and education set the stage for a smooth onboarding process as clients expand their opportunity set.
Incorporating alternative investments breathes new life into tired traditional allocation models. Alts help construct portfolios that are truly diversified by return driver – not just asset class.
Private equity minimizes volatility. Real estate hedges inflation. Crowdfunding taps into venture-scale returns. Peer lending generates consistent income.
The alternatives landscape offers something for clients across the risk spectrum if you take the time to properly educate yourself on prudent implementation using institutional-grade platforms.
Relying solely on stocks and bonds exposes clients to an unnecessary level of risk in today’s investing climate. Cast a wider net using alternatives to manage risk while boosting returns and income. The time has come to break free of outdated constraints and expand client access to the opportunities institutions have long enjoyed.
