As the S&P 500 becomes more concentrated due to strong performance of the “Magnificent Seven” technology stocks, private wealth advisors are deepening their search for compelling alternative investment strategies to further diversify client portfolios. A key element to consider when diversifying is the different stages of life that clients are in, especially those in later retirement.
Solving for Income Shortfalls
With inflation rising dramatically over the past two years, older investors continue to benefit from more uncorrelated income streams generated through alternative income strategies.
Examples include legal-settlement finance, reinsurance and niche income-producing strategies such as royalties (film, music or pharmaceuticals) and hard lending (real estate, equipment leasing, accounts receivable and shipping finance).
Many of these strategies have floating rates that protect investors in higher inflationary environments. This has made these strategies especially attractive in this environment.
It’s important to note that alternative income strategies typically require some type of lock-up that won’t likely provide liquidity upon demand, but they can provide regular higher income distributions throughout the year. This shortens the duration of these strategies and may make them better income solutions for client portfolio regardless of the client’s age.
While wealth advisors have generally found income-producing strategies to be the most popular way to implement alternative investments into their client portfolios, they also utilize hedge funds as a wealth preservation tool for older clients. Multi-strategy or long/short equity funds that emphasize capital preservation and risk reduction have been particularly popular.
These types of funds can provide more uncorrelated diversification benefits to client portfolios instead of just holding public stocks or index positions as the main equity allocations. This is especially important as the S&P 500 gets even more concentrated with the ultra-mega-cap technology names.
One of the biggest issues advisors raise when considering hedge funds is their potential tax inefficiencies. Hedge funds can produce significant short-term taxable gains that impact after-tax returns each year. However, holding these funds in more tax-advantaged retirement accounts such as IRAs can completely remove these short-term trading tax inefficiencies for private clients.
In addition to hedge funds, private equity can also help diversify client portfolios and reduce volatility, especially during periods of public market dislocation. Lower-and middle-market private equity has been attractive historically from an entry valuation standpoint compared with the public markets. These private-equity strategies also enable fund managers to actively improve the fundamentals of their portfolio companies as they prepare to generate exit opportunities to return capital to investors.
The main challenge for wealth advisors when considering private equity for older clients is the lengthier lockup periods that accompany these strategies. Their liquidity is out of an advisor’s control. However, there are ways to mitigate this challenge through estate-planning structures.
For example, advisors can lengthen the investment time horizon into future generations by investing like a typical family office. Investors should consult their estate planners for guidance on establishing these types of trusts.
Beyond the estate planning solutions, the asset management industry continues to introduce more liquid private-equity structures through both interval fund offerings and tender-offer fund offerings.
While these types of funds can work in theory, we do caution that market conditions might impact the planned liquidity of such products, especially those that hold private equity.
For example, during periods of heightened volatility investors might look to redeem their investments at the same time. But the products may not have enough liquidity to accommodate heightened demand for redemptions. Funds that hold private investments such as private equity often cannot be sold easily.
Regardless, private equity can add a needed diversifier (and volatility reducer) to private wealth portfolios especially when public market valuations can appear stretched.
Conclusion
Alternative investments can be utilized for many purposes for older clients. Investors in later-stage retirement are typically most concerned with maintaining a stable income stream to maintain their lifestyles and they are focused more on basic wealth preservation rather than aggressive portfolio growth that requires more risk.
Accordingly, alternative income strategies can provide consistent cash flow regardless of the broader macroeconomic environment for these older investors. In addition, incorporating certain types of hedge funds and private equity can help investors stay ahead of rising inflation to protect purchasing power without incurring the same type of drawn-down risk as public equities.
By adding alternative strategies to their older clients’ portfolios, wealth advisors can create more prudent financial solutions for these clients.
Frank Burke is CIO of PPB Capital Partners, based in Conshohocken, Pa. The company offers alternative investment solutions and streamlined processing to the wealth advisor community.
