This is the first part of a series about alternative investments. In this article, we examine the universe of alternatives, what options are available and the overall pros and cons. Articles scheduled to be published during the upcoming weeks will review the various options in detail.

If commodities were the hot product of the 2000s, alternatives are the flavor of the decade for the 2010s. From hedge funds and natural resources to venture capital and derivatives, high net worth individuals are clamoring for investments that they believe will give them and their portfolios an edge over the traditional mix of stocks, bonds and cash.

“A good way to look at alternatives is that they are either doing one of two things for you: they are adding alpha, or return, or providing an alternative beta or diversification factor for the portfolio,” says Jeff Nauta, a wealth manager with Hendrickson Nauta wealth advisors in Grand Rapids, MI.

The class of alternative investing strategies is broad and is growing all the time. It includes hedge funds, private equity, private loans, natural resources, commodities, limited partnerships, derivatives and use of techniques such as leverage, futures contracts and short selling.

Pros and cons

But alternatives aren’t all sunshine and roses. Just like any other investment, they have their drawbacks. Frequently, returns are overhyped, strategies and execution are opaque, investments are illiquid and structures are complex. So it’s extremely important for wealth managers to be knowledgeable about the alternatives they recommend to clients, and to outsource any part of the alternatives investing universe that they aren’t expert in to quality professionals.

And while investing in alternatives can be enticing to both wealth managers and their clients, there are solid reasons to steer clear, according to Tim Courtney, chief financial officer at Burns Advisory Group in Oklahoma. “As a general rule, we’re kind of skeptical,” he admits. “Alternatives, at least in the way they are sold or marketed, are advertised as an opportunity to get higher returns with lower risk. That’s where our red flag gets raised.”

In the world of investing, it’s not possible to gain return without courting risk; this is a basic principal of investing too often ignored or brushed aside when dealing with alternatives, he adds. “I don’t think you can get higher returns without taking on risk of some kind,” he continues. “That risk may not show up every year, but it’s there.”

Courtney isn’t against all alternatives, but believes it’s vitally important for wealth managers to thoroughly engage in due diligence when considering any of these investments for client portfolios. “Give some thought to how the position might turn against me when markets go the other way,” he advises.

Like Nauta, he likes the fact that alternatives provide diversification for client portfolios and believes that’s the major selling point. “If I can get an average of 4 per cent a year from something that behaves a little differently than the other positions in a portfolio, that’s a selling point for me,” Courtney says.

Venturing into new territory

Alan McKnight, a partner and director of global investment strategy at Balentine Investments in Atlanta, GA, likes alternative investments such as hedge funds because they can venture into territory where traditional mutual fund managers can’t go and their compensation is directly tied to their performance. “Of primary importance to us is the concept of the absolute return benchmark,” he says. “Whether you like hedge funds or not, hedge fund managers get paid to generate positive performance. We like that alignment and the incentive structure.”

Hedge funds and other alternatives have the freedom to go outside of a traditional investment mandate and take a market neutral approach or engage in short selling or whatever strategy they think is appropriate in a given market, he continues. He believes that risks, such as the lack of liquidity inherent in investing in vehicles such as hedge funds and private equity, can work within client portfolios if managed appropriately. For example, if a client needs liquidity, make sure that’s available in another part of the portfolio, he says.

Transparency

Transparency, or lack thereof, is another issue with alternatives. That’s why Courtney prefers alternatives packaged in publicly-traded vehicles like ETFs and mutual funds. The companies that sponsor those types of investments must disclose information regularly in the form of annual reports, prospectuses and statements of additional information.

Julie Murphy Casserly, a financial advisor with JMC Wealth Management in Chicago, IL, prefers privately-traded alternatives such as limited partnerships because their structure insulates them from the volatility of the markets. She feels comfortable vetting the finances of those alternatives and steers away from any that aren’t transparent enough.

Types of alternatives

Alternative investments include these categories:

• Oil and gas infrastructure: these investments, typically limited partnerships but also available as publicly-traded stocks that house limited partnerships, invest in the infrastructure such as pipelines that transport oil and gas.

• Venture capital: investment companies that take stakes in start-up companies with an eye to taking them public in future years. Many venture capital funds lock up money for five to 10 years at a time.

• Hedge funds: funds that engage in alternative strategies and practice an absolute return strategy designed to provide a positive return to investors regardless of the market environment. Hedge funds frequently have high investment minimums and are lightly regulated.

• Commodities: these investments are usually lumped into the alternatives space – although they can be categorized on their own – because they don’t act like stocks and bonds. The category includes precious metals, energy, food products and others.

• Real estate: while many include real estate as a traditional investment option rather than an alternative, it can be classified as both. Alternative real estate can include privately traded Real Estate Investment Trusts (REITs), private real estate loans and foreign real estate.

• Natural resources: resources such as timber and water are becoming more popular as investors appreciate their value and potential scarcity. Most natural resources are available for investment via limited partnership structures or hedge or mutual fund