Advisors want to use alternatives. Here are 3 reasons they aren't

Alternative investments are an enticing proposition for retail and institutional investors alike amid an inflationary and volatile market environment. Projections show institutional capital allocated to alternative investments will grow 8% annually over the next decade, according to a 2023 report by Bain & Co. Despite the erosion of private equity’s returns by inflation and rising interest rates, the industry’s $3.7 trillion of dry powder — namely unspent capital — puts general partners in a strong position to withstand the downturn and invest again quickly once markets normalize, according to the Bain report. And although hedge funds, in aggregate, have suffered losses, certain strategies — including global macro — have generated strong returns.

As a result, it is likely that financial advisors will continue to build up their exposures to alternative investments, including real estate, commodities, private equity, private debt and hedge funds. Broadridge’s recent biannual survey of financial advisors revealed that 67% of financial advisors used private funds or alternatives in the third quarter of 2022, up from 51% in first quarter of 2021. Furthermore, among those advisors currently using alternatives, 52% plan to up their allocations to alternatives moving forward.

The data shows that 36% of financial advisors said that the need for diversification was the main reason as to why they are investing in private funds, followed by their non-correlation with equity markets, which was cited by 27% of respondents. An additional 9% of advisors said they used private funds for hedging purposes, while 6% felt they offered superior performance.

Despite the compelling investment case for alternatives and growing appetite among financial advisors for these strategies, many advisors surveyed said that they lacked the products and support from asset managers to meet rising retail demand.  Tellingly, the survey noted that only one in four financial advisors across wirehouse, regional, independent and RIA channels  are “very satisfied” with their firm’s alternative investment funds or products, while one in six is actively “dissatisfied.”

Here are three reasons why.

Lack of choice. Of those financial advisors who said they are dissatisfied with their firm’s offerings, 60% cited the lack of choice as being the main problem. This comes as some broker-dealers limit the number of alternative investment products they make available to their advisors. Some broker-dealers do not have the capacity to vet all of the funds due a combination of staffing, complexity, liability and risk.

Hard to use. A further 22% of advisors said they found alternatives challenging to use and difficult to understand. Education by asset managers is critical here if this problem is to be overcome. It is vital that managers explain to financial advisors what alternatives do and how their operating models work. Through greater transparency on the part of the manager, it will become easier for financial advisors to navigate some of the challenges they may encounter when investing into alternatives.

Liability.  Some broker-dealers and financial advisors simply do not want to incur the added liability that comes with adding investments to an investor’s portfolio, such as limited opportunities for high-net-worth and mass affluent investors, lack of investor education and illiquidity.  Alternatives deliver an attractive risk-return profile for investors with a solid financial base and diversified portfolio, yet advisors need to be careful to recognize which clients will tolerate the more illiquid and volatile nature of these investments.

NEED FOR CONTINUED DIVERSIFICATION

The current market conditions underscore the need for continued diversification as investors are challenged within the public markets. Against this backdrop, the asset managers and advisors in the investment ecosystem need to understand these emerging products, how and who to deploy them to and the role of alternatives in an investor’s portfolio.

Matt Schiffman is principal of distribution insight at Broadridge.