INSIGHTS FROM ADAM GORLYN

Adam Gorlyn is an investment management professional hired by Fountainhead to consult on its alternatives investing approach as we continue to enhance our OCIO services and offerings.

Alternative investments provide a myriad of potentially valuable benefits for investors, balanced with a cost of complexity and illiquidity. In a series of articles, we will explore the increasing popularity of alternative investing. We focus on how investors can analyze and utilize alts as part of their overall strategic asset allocation in order to increase the likelihood of achieving desired outcomes.

SIZING ALTERNATIVE ALLOCATIONS FOR CLIENT PORTFOLIOS

In our first article on alternative investments, we highlighted some of the reasons for the significant asset growth in the space and the potential opportunities we see across multiple strategies. In our prior article, we focused on the many time-intensive steps necessary to thoroughly evaluate alternative strategies inclusive of a high-level due diligence checklist and a mini case study on private equity strategies. Our concluding article in this series is focused on how to appropriately size and incorporate an alternative investment within a client portfolio. 

Investing in a way that meets objectives starts with understanding investor needs, crafting the right approach, then applying it with consistency. Without a solid framework, results can vary widely. For instance, one may find themselves over-exposed to a (i) specific sector of the market, (ii) strategy approach, or (iii) higher level of risk than expected. These points are relevant when building any asset allocation but are particularly important to consider when allocating to alternative strategies given their lack of liquidity, meaning it is typically difficult to reverse out of an exposure in reaction to a shift in any factor negatively affecting the investment (e.g., a macro event like Covid or a micro event like a significant partner leaves the firm managing the investment).

According to a 2022 Cerulli report, studies have suggested that high-net-worth individuals are increasing their allocations to alternatives, with an average allocation of 9% in 2022[1]. We believe the average investor can afford to have an allocation that is greater than 9%. We believe 9% is quite low and speculate that this low limit is due to the complex nature of alternative investments and the struggle to appropriately incorporate the product class into one’s practice.

We believe that many clients with steady earnings and a long-term investing time frame can support a 20% – 30% allocation to alternatives. The appropriate allocation to alternatives for any particular client is dependent on a number of factors, including investing time frame, liquidity needs, diversification benefits, and opportunity. For example, it may not be prudent for a higher earner in a risky job (e.g., entrepreneur), who is just beginning a family to allocate anything to illiquid alternatives. On the other hand, an established family office may be justified in allocating 50% or more to alternative investments. And of course, it’s also true that some people who can financially afford the total loss of their investment still can’t tolerate the risk emotionally or psychologically.

ALTERNATIVE RISK CHARACTERISTICS

Like ETFs and Mutual Fund strategies, alternatives can typically be bucketed into defined risk exposures. For example, venture capital private equity (VC PE) strategies are generally classified as a high risk, high reward exposure, while a private, collateralized debt investment with a high loan-to-value (LTV) will most likely provide a lower risk, lower reward exposure. Both strategies may serve clients well. The VC PE strategy may provide higher reward than can traditionally be found in public markets while taking advantage of an illiquidity premium and providing overall diversification as compared to other equity exposures. Meanwhile, a collateralized debt investment with a high LTV may provide enhanced yields due to the private nature of the transaction, an inherent illiquidity premium, and with a variable interest rate, providing diversification as compared to public market investment grade exposure which is predominantly conducted with fixed interest rates.

PORTFOLIO ALLOCATION AND SIZING

Asset allocation models are generally separated by risk exposures. As an example, a growth-oriented model will generally have more exposure to the technology sector (e.g., growth equity) as compared to a more conservative model. Yet, both models will have exposure to the technology sector, just at different allocations. Similarly, a VC PE exposure may be appropriate for a conservative investor, however it would need to be sized appropriately relative to the investor’s overall portfolio exposure. For instance, perhaps a client with a higher risk exposure may be allocated a 5% overall VC PE exposure, while a more conservatively oriented client would be allocated a 2% overall VC PE exposure.

CONCLUSION

Alternatives should play a significant role in all advisors’ offerings. They provide the potential for diversification and enhanced returns. They also meet the need for more sophisticated investment options, and a capability to provide differentiated offerings for an existing and prospective client base, not to mention the opportunity to build relationships. That said, alternatives can also be incredibly complex to fully comprehend and, due to their liquidity profile, once an investor has allocated to an alternative investment, it may take years to exit which has the potential to impact the client’s outcome.

It is important not only to conduct robust and thorough due diligence on alternative strategies, but to be process driven and thoughtful when incorporating and sizing each investment within a client’s overall portfolio. Getting the overall investment thesis of an alternative correct but over or under exposing is another risk in utilizing alternatives. Each alternative investment has to be analyzed in light of many factors, including the client’s overall risk exposure, how the characteristic of the particular alternative investment aligns with other alternatives, and how the investment aligns with the overall current exposure of the client’s portfolio. Alternatives have more risks to consider relative to traditional investments given their complexity and the fact that an error in analysis or sizing can take years to reverse – an easy way to lose a client relationship.

Disclosure

Alternative investments are not appropriate for all investors. Some alternatives, including private placements, have minimum investor qualifications. Private placements are generally offered only through a private placement memorandum or other offering documents provided by the issuer and may be purchased only by accredited investors. In some cases, in addition to being accredited, investors must also meet the definition of “qualified purchaser” and/or “qualified client.” This paper is not intended as investment advice or the recommendation of any security or class of securities. Fountainhead provides investment advice only to clients, and only after assessing individual client needs, objectives, risk profile, and investment profile. This paper describes general risks and opportunities of investing in alternatives. The actual risks and opportunities of any specific investment must be carefully reviewed before being employed in a client portfolio. Fees associated with alternative investments are separate from and in addition to the advisory fees charged by Fountainhead. No investment can guarantee positive returns or the prevention of all loss.

[1] The Cerulli Report—U.S. High-Net-Worth and Ultra-High-Net-Worth Markets 2022: Shifts in Alternative Allocations.