Alternative investments often require a certain level of patience as many of these assets lack the liquidity inherent in the public markets. However, there are several benefits associated with taking a long-term approach by investing in illiquid alternatives. Pretty much anything that does not fall within the definition of traditional stocks and bonds can be loosely categorized as alternative investments. The more common illiquid alternative investments many are familiar with are venture capital, private equity, hedge funds and fixed-income products.
Alternative investments have been on the rise since 2005 as more investors and financial advisors have begun to explore investment options outside of traditional stocks and bonds. A McKinsey & Company report shows that the global AUM of alternative investments has risen by 119% over the last 8 years from 2005 to 2013. Here are three benefits of investing in illiquid alternative investments.
(1) Mitigate Market Volatility
Alternative assets often cushion market volatility present in more traditional investments like those found in the public markets. This is accomplished by investing in asset classes like private equity that feature low correlation to the markets.
Investors all too often have the tendency to react hastily when markets turn sour as they generally lack the ability to fully understand the underlying causes of this volatility. The long lock-up periods of alternative investments reduce preemptive reactions to risk and create a natural hedge against the myopic knee-jerk reactions of the average investor. Fear-based selling and behavioral investing are tempered by the illiquidity present in many alternative investments.
(2) Lower Transaction Costs
Short-term investing often requires high amounts of turnover, leading to the creation of high transaction costs. While short-term investing sometimes yield high returns, many of these benefits are offset by the costs associated with maintaining and rebalancing a portfolio. It is often difficult to create a model to generate an efficient portfolio for maximized returns while limiting high transaction costs.
Alternative investments often have higher upfront fees compared to other traditional investments, but this is ameliorated by the fact that these investments are typically not subject to high turnover and ongoing maintenance and transaction costs.
(3) Tax Benefits
While not unique to alternative investments, long-term investments (longer than 12 months) have certain tax benefits. These longer-term investments are subject to long-term capital gains tax, which is lower than the taxes incurred from short-term investments. Additionally, capital gains tax is generally only incurred upon realized gains. As a result of the longer holding periods of illiquid alternatives, these investments may hedge against short-term capital gains taxes. Consult with your financial consultant and/or tax advisor in order to determine which investments may be best suited for your portfolio and long-term investment strategy.
Disclaimer: This podcast is not an offer of investment opportunities or investment advice. Any investment decisions should be made after consulting with your financial advisor.