EP Wealth Senior Vice President, Advisor, Partner, James P. Henry, MBA explains how alternative investments like private equity, real estate, and private credit may fit within a broader financial plan, and what clients should consider before diversifying beyond traditional assets. 

Strategies for Diversifying Beyond Traditional Assets

For clients who are looking to diversify beyond traditional public market investments like stocks and bonds, alternative investments such as private equity, real estate, and private credit may be worth exploring. At EP Wealth, we approach that conversation by first conducting a detailed financial plan. We start by getting to know a client's unique situation, including their risk tolerance, goals, income needs, time horizon, and overall financial picture. From there, we can evaluate whether private investments might serve a specific role within the portfolio as part of that broader plan.

In this blog, I share some of what I walk clients through when alternatives come up in the planning process, including:

• When alternative investments may be worth considering as part of a financial plan
• Common misconceptions about alternatives
• How allocation decisions are typically made
• Types of alternative investments and the objectives they may serve
• When alternatives may not be appropriate
• What to consider when evaluating a deal brought to you by someone in your network

Every client's situation is different, and not every strategy discussed here will be the right fit for every person. That's why it's important to work with a financial advisor who can help evaluate whether alternatives may have a role in your portfolio.

When Alternative Investments May Be Worth Exploring

Whether alternatives may have a role in a client's portfolio is something we evaluate during the financial planning process. Some of the signals that might point us toward considering alternatives include:

• A long time horizon with no immediate liquidity needs. Many alternative investments are illiquid by nature, so we want to make sure a client has a portion of their portfolio they won't need to access for an extended period. If that flexibility exists, it opens the door to asset classes that may not be available through public markets.
• A desire for diversification beyond public markets. Some clients have built portfolios primarily around traditional stocks and bonds and are interested in broadening that exposure beyond what public markets offer.
• The potential for different return or volatility characteristics. Some alternative strategies aim to deliver returns that behave differently from public markets over the long run, or to reduce overall portfolio volatility — though outcomes vary depending on the strategy and the manager.
• Interest in tax-advantaged income strategies. For clients in higher tax brackets, certain alternative strategies may offer income that is structured differently from a tax perspective.

To illustrate how a tax-advantaged strategy might work in practice: some private real estate funds, including a net lease fund used at EP Wealth, distribute income primarily in the form of return of capital. Rather than being taxed as ordinary income in the year it's received, the distribution reduces the investor's cost basis in the position. If the investor eventually sells, they may face a larger capital gain at that point—but in the meantime, they've received income without the ordinary income tax burden. For a client in a higher bracket, that difference in how the income is taxed can be meaningful.

Common Misconceptions About Alternative Investments

Some misconceptions about alternative investments can lead clients to rule them out before fully exploring whether they might be a fit. Here are a few I've encountered regularly in my work as an advisor.

"Alternatives are only for ultra-high-net-worth or institutional investors."

That may have been closer to true in the past, but in recent years, many alternative investments have been structured in a way that makes them more accessible to a broader range of high-net-worth clients. Access has improved quite a bit, though awareness is still catching up. As advisors, part of our role is helping clients understand what may now be available to them.

"Public markets are more diversified."

Private companies make up around 87% of U.S. companies with over $100 million in revenue. The private market is significantly larger than the public market in terms of number of companies, which means there is a wide range of companies that private funds may have the opportunity to invest in. Meanwhile, public market indexes have become more concentrated in technology stocks, with some of the largest tech companies now representing an outsized share of the broader indexes. That concentration is one of the reasons some investors look to private markets for additional diversification.

"Alternatives are too complicated to understand."

Some clients assume that private investments are a “black box,” and that they won’t be able to understand what's happening under the hood. While some strategies are more complex than others, many alternative investments—like real estate, infrastructure, and private credit—are relatively straightforward in what they aim to achieve. Private investment managers have also become more transparent in recent years, making more information available to investors about holdings, strategies, and portfolio activity.

What to Evaluate When Considering Alternatives 

How Allocation Decisions Are Made

There's no one-size-fits-all formula for determining how much of a portfolio should be allocated to alternative investments. The decision generally involves a few key steps:

1. Start with the financial plan. The appropriate allocation depends on a number of factors that come out of the planning process, including portfolio size, overall net worth, time horizon, and income needs.
   
   
2. Determine a suitable range. At EP Wealth, the portion of a client's portfolio allocated to alternatives typically falls somewhere between 0% and 25%. In some cases, alternatives may not be suitable at all. In others, a meaningful allocation may be appropriate.
   
   
3. Let objectives guide the allocation. Is the goal income generation? Long-term growth? Diversification beyond traditional asset classes? Tax-advantaged income? Each of those objectives may point toward a different type of alternative investment, and a different allocation size.

Types of Alternative Investments and the Objectives They May Serve

Over the years, I've found that investors tend to paint alternatives with a broad brush, treating them as a single asset class. The reality is that there are a number of distinct investment types within the alternatives category, and they differ meaningfully in terms of what they aim to achieve, how they're structured, and what the terms look like for investors.

Here's a brief overview of some of the more common types:

• Private equity involves investing in private companies, often with the goal of long-term capital appreciation. These funds typically have longer lockup periods than public market investments.
• Venture capital is a subset of private equity focused on early-stage companies. It carries higher risk but may offer the potential for significant growth over time.
• Private credit involves lending to companies or projects outside of traditional bank financing. These strategies may offer yields that differ from what's available in public fixed income markets.
• Private real estate involves investing in properties or real estate portfolios that are not publicly traded. Some of these strategies may offer tax advantages, depending on how distributions are structured.
• Private infrastructure involves investing in physical assets like utilities, transportation, or energy systems. Demand for these services tends to be relatively consistent, which may make infrastructure strategies appealing to investors seeking more predictable cash flows compared to some other alternative investment types.
• Hedge funds use a variety of strategies that can range from relatively straightforward to quite complex. In my experience, hedge funds can be more opaque than some of the other alternatives, and clients may have expectations around outperformance that don't always align with actual outcomes. Not all hedge funds are structured the same way, and not all deliver the same results. Careful evaluation is needed before considering this category.

Growth-Oriented Strategies

For clients who are still in their high-earning years, have a long time horizon, and are not relying on this portion of the portfolio for income, private equity and venture capital may be worth considering. These strategies are typically oriented toward long-term capital appreciation, and we generally look for a time horizon of at least 7 to 10 years for a traditional private equity fund.

Because of that time commitment, we want to make sure the allocation is sized appropriately. We want ample liquidity elsewhere in the portfolio so there's a low risk of the client needing to access those funds if their income situation or life circumstances change.

Income-Oriented Strategies

For clients whose objective is income generation—whether they're approaching retirement, already retired, or simply looking to complement other income sources—private credit, private real estate, and private infrastructure may be strategies worth exploring.

These can serve a different role in the portfolio than traditional fixed income, and depending on the specific fund, may offer income with different characteristics. As I mentioned earlier, some private real estate strategies may distribute income primarily as return of capital, which may offer potential tax advantages for clients in higher brackets.

Manager Selection and Fund Composition

Once you've identified the right type of alternative investment, two additional factors can meaningfully affect the outcome.

The first is manager selection. In any alternative asset class, there is significant dispersion in performance among managers. The skill level involved in selecting the underlying investments varies, and the manager you choose to run a particular strategy can have a substantial impact on the results.

The second is something clients may not think about as often: the composition of the other investors in the fund. Whether a fund's investor base is made up primarily of retail investors or of clients who came through an advisory channel like a larger RIA can affect how the fund behaves during periods of stress.

For example, in the current environment with private credit, some of the redemption pressure we've seen has been driven more by retail investors than by institutional ones. When redemptions are oversubscribed, investors who expected to access a certain amount may find that they're capped. The actions of other investors in the fund can affect your experience as an investor, and that's something worth being aware of going in.

When Alternatives May Not Be Appropriate

There are situations where we might advise a client against moving into alternatives, even if they've expressed interest.

• Potential liquidity needs. If the financial plan reveals that a client may need to access portfolio funds in the foreseeable future, the illiquid nature of most alternative investments may not be a good fit. Liquidity constraints can become even more pronounced during certain market cycles. In private credit, for example, there have been recent situations where redemption requests exceeded what the fund was able to accommodate, and investors found that their ability to withdraw was capped.
• Chasing returns. Some investors become interested in alternatives after hearing about strong performance in a particular asset class or strategy. The risk is that expectations may be shaped by headlines that don't reflect the typical investor experience. Eye-catching return numbers may not account for factors such as fees, lockup periods, or the possibility that past performance may not repeat. Wanting access to strong returns is understandable, but it's not on its own a reason to invest in an asset class that may not fit a client's financial plan.

Evaluating an Opportunity Brought to You by Someone You Know

One situation we see frequently as advisors is when a client is approached by a colleague, friend, or family member with a private investment opportunity—it might be a real estate deal, a startup, or a business venture—and brings it to us for input.

When that happens, there are several layers to work through:

• The relationship. The first thing I ask a client is: How well do you know this person, both personally and professionally? Is it someone you’ve trusted over a long period of time, and have you seen this person operate in a professional setting?
• Access to information. What financial details are available for review? Can the client provide us with enough material to conduct meaningful due diligence? We want to understand the terms of the deal, including liquidity provisions, lockup periods, fees, and whether there are performance fees on top of the base fee structure.
• Does it fit within the broader plan? How does this investment align with your overall objectives? That evaluation helps us think about allocation size. If the opportunity involves a single asset—an apartment building, a startup, a single company—we would typically consider a smaller allocation than we might for a diversified fund, given the concentration of risk.
• The personal dimension. If this deal doesn't work out, how will that affect your relationship with the person who brought it to you? Mixing business with family and friends carries personal risk that extends beyond the financial side. I've seen it work out well in some cases, and I've also seen situations where it jeopardized the relationship and the client regretted the decision.

Part of my role as an advisor in these situations is helping you understand the risks involved so that you can set clear expectations before you commit. If you go in understanding those risks, and your mindset is that you're only allocating a small amount relative to your overall portfolio and you're not going to be resentful if you lose it, that can be a very different starting point than going in with a more significant personal investment and expecting a certain level of return. The higher your expectations, the more potential strain a disappointing outcome can put on your relationship with the person who brought you the opportunity.

The Financial Plan Comes First

Everything I've discussed in this blog comes back to the same starting point: the financial plan. That’s where we identify what a client's portfolio needs to accomplish, both in the short term and the long term. From there, we may determine that an alternative investment could serve a specific purpose within the portfolio.

My role as advisor is to help clients understand which alternatives, if any, may be appropriate, and to make sure that any decision fits within the context of what we're trying to achieve for their financial future.

If you're interested in exploring whether alternative investments may have a role in your financial plan, EP Wealth's financial advisors are here to help. Contact an advisor to start the conversation.

DISCLOSURES:

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• Information presented is general in nature and should not be viewed as a comprehensive analysis of the topics discussed. It is intended to serve as a tool containing general information that should assist you in the development of subsequent discussions. Content does not involve the rendering of personalized investment advice nor is it intended to supplement professional individualized advice.
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