There are a number of ways to answer this question and the topic requires more than two minutes, so please look for follow-up and further information on the topic of alternative investments from TGIF 2 Minutes.
For starters, the key word in the question, “Does a portfolio need alternatives?” is need. And for reference, alternatives investments are often nicknamed “Alts” in conversations. Finally, “alternative investments” is a name mainly given by the financial services industry for:
- non-public investments
- private equity, private debt, and private real estate
- venture capital (VC)
- hedge funds
- and a whole host of other longer-term, less liquid and illiquid investments.
It can be argued fairly strongly and quantitatively that most portfolios do not need alternatives.
With this said, there are clients who would like to explore and allocate part of their portfolio to alternative, private, and less liquid investments for various, justified reasons. Most often the desire is (obviously) for greater potential return. The point needs to be emphasized that greater potential return carries greater risk and, most of the time, a far longer period of time to realize those returns.
A major concern in the shorter term is taxes. Often, a private or illiquid investment, far before a major “return event”, generates periodic, short-term taxable income that is taxed at (higher) ordinary income rates which are most often 32%, 35% and 37%, versus long-term capital gains tax rates which are lower at 15% or 20%, (the 20% being most likely for those reading this note). There are additional capital gains-related taxes that were also tacked on to the Affordable Care Act (a.k.a. Obamacare) for the highest income brackets. Leave it to say that taxes are always a consideration and can be even more so for private and slightly more complicated investments.
Still, private and less liquid investments can make sense, as the universe of publicly traded stocks and bonds has stayed somewhat constant over the past decade. Whereas the universe of privately available stocks and bonds has exploded. In a number of cases, well-known and profitable public companies have been taken over by private equity firms, so private equity re-opens the opportunity to invest in those formerly public companies. There are also publicly traded ETFs and mutual funds that invest in private and “alternative investments”. Often these funds come with “gates” to access client monies meaning that liquidity is limited by amount and timing, for example, quarterly with a maximum amount that can be withdrawn or sold. But these publicly traded funds can make it simpler to gain access to private investment opportunities.
Other considerations include:
- correlation of private investments to publicly traded investments (higher correlation of private investments kind of “cancels out” the perceived benefits; lower correlation adds to the perceived benefit)
- investment costs and fees
- accuracy of valuation of private, less liquid and illiquid individual holdings.
There is far more to say about the benefits and drawbacks of private and venture capital investing. As with most less liquid investment vehicles, including annuities, there can be a place in a portfolio once the critical parts of financial planning have been accounted for and spending and lifestyle are already protected.
This material has been prepared for informational purposes only and is not intended to provide, and should not be relied upon for, tax, legal or accounting advice.