The rethinking of traditional investment allocations is causing high-net-worth (HNW) investors to seek ways to diversify their investment portfolios, especially given the current low yield environment. The increased allocation to alternative investments, such as private equity, hedge funds, commodities and real estate, is aiding HNW investors in achieving improved portfolio diversification, a hedge against future inflation and increased current yield, with certain tax benefits in the case of real estate.
Portfolio challenges for HNW investors
HNW investors have traditionally looked to stocks and bonds, with their market breadth and attractive liquidity, for the bulk of their portfolio allocations. While historically effective, the traditional approach to investing will be increasingly challenged as future equity returns are likely to be significantly lower and fixed income returns continue to be low in this “new normal” environment. HNW investors, and to a greater extent ultra HNW investors, are showing greater interest in alternative assets as a means to diversify their portfolios and achieve more attractive risk-adjusted returns.
Given the current liquidity premium characteristic of conventional equity and fixed income markets, and the relative increased (liquid) cash positions among HNW investors, investment managers, generally, are of the belief that most HNW portfolios are over-allocated by prior standards. Further, many alternative investments now offer certain forms of liquidity, enabling increased allocations in alternatives yet with flexible exit strategies.
The increasing shift toward alternatives
Until recently, alternatives warranted a roughly 10 percent allocation to the typical HNW investor, perhaps even up to 20 percent. The move towards higher allocations for alternative investments within a HNW investor portfolio is increasing, to a large extent due to the low correlation when compared to traditional asset classes. Investment managers are commonly advocating a much greater allocation to alternatives, ranging from 20 percent to 40 percent. For ultra HNW investors, an alternative asset allocation in the mid-40 percent range is not uncommon.
A considerable amount of new independent RIAs are being formed to allow advisors who are leaving traditional brokerage firms to provide clients with an “open architecture” platform. This creates increased flexibility in providing clients more diverse investments, including alternatives, than the limitations incumbent with approved brokerage platform products.
Additionally, advisors are leaving traditional brokerage firms to avoid the perceived conflict of earned commissions on proprietary products, as opposed to compensation for assets under management in an open architecture platform. Not only does this diversification help HNW investors, it eases the difficulty by smaller investment managers in accessing advisor platforms.
Tracking the trend of increasing alternatives allocation is worth a longer look, as it is indicative of a shift by HNW investors and will result in increased capital flows into real estate. By combining a variety of alternative assets in a HNW portfolio, notably real estate, a more optimal diversification can be created, one that avoids the liquidity premium found in traditional asset classes, benefits from low correlation and provides investors with enhanced portfolio returns and current yield.
Robert Brunswick is the co-founder and CEO of Buchanan Street Partners, a real estate investment management firm that focuses on value-add investing by providing debt and equity capital to owners and operators of commercial real estate as well as buying direct investment for their own account.