Alternative investments are about to become much more accessible to everyday investors. The Department of Labor is currently reviewing rules that would allow 401(k) plans to offer alternative investments (alts) which includes assets like private equity, physical real estate, venture capital, hedge funds and other non-traditional assets. These rule changes are expected to take effect in 2026.
As this rollout approaches, expect an aggressive marketing push from Wall Street touting the extraordinary benefits of these investments. However, the reality is never as rosy as marketing suggests. Alternative investments should be viewed as specialized tools for portfolio construction. They can be useful for specific financial situations, but far away from a cure-all solution.
There’s a reason these investments have traditionally been limited to pension funds, endowments and family offices. Alternative investments require a great deal of in-depth financial market knowledge to separate the good from the not-so-good strategies. Alts are notoriously difficult to assess objectively, rely on non-standard performance metrics, and operate under less stringent reporting requirements than traditional securities.
Unlike stocks and bonds, alts often lack comprehensive investor protection and typically come with substantially higher fees. The typical pension fund or endowment has entire teams of financial professionals and consultants who carefully analyze investments before implementation. Individual investors acting alone often lack access to such valuable resources.
However, while some types of alts may indeed be inappropriate for average investors’ portfolios, dismissing the entire category may result in missed opportunities. The alternative investment universe encompasses varied strategies and asset classes, with some offering genuinely unique return streams that don’t correlate to the classic economic factors that affect stock and bond performance.
Investors have enjoyed a remarkable run with the S&P 500 up over 200% from its March 2020 COVID lows. However, this spectacular performance has pushed some market segments into overvalued territory. With the Federal Reserve potentially facing renewed inflation concerns and economic growth showing signs of moderation, traditional asset classes may struggle to deliver the returns investors have come to expect in recent years.
Fix the Roof While the Sun Is Shining
Suggesting alternative sources of returns may seem counterintuitive when traditional markets appear to only move up and to the right. However, the foundation for future capital market returns may be less robust than recent performance suggests. If forecasts for modestly increased rates of inflation and a slowing economy do take hold, capital market returns may be subdued.
In the equity market, valuations are elevated in some areas and below average in others. It is fair to say that on balance the US equity market is at the high end of historical valuations. While this means very little for short-term market performance, it could suggest more modest equity returns over longer time frames. Much of today’s investor optimism depends on AI related developments, which is impossible to predict.
In fixed income, current yields on traditional bonds are indeed near the most attractive levels we’ve seen in a long time. The Ten-year Treasury is yielding 4.05%, the yield was 0.68% five years ago. However, inflationary pressures and debt market dynamics may constrain total returns moving forward.
The Federal deficit is large and growing. This could lead to higher yields, particularly for longer-term bonds, as investors must digest significant additional Treasury market supply. These changes, combined with potentially elevated inflation rates, could impact the broader bond market. While we can’t say anything in finance with absolute certainty, we’re confident that policymakers in Washington will not run a balanced federal budget any time soon.
This matters because most investors hold bonds as a hedge against equity risk in their portfolios. When equity markets stumble, bond markets have historically provided offsetting stability. In periods of weaker economic growth accompanied by modestly higher rates of inflation this relationship may not hold to the same extent. Essentially, fixed income may not provide the same level of diversification that investors have come to expect.
This is where alternative investments can add value. Unlike traditional assets, many alternative strategies are designed to generate returns independent of both equity and bond market performance. During periods of muted capital market returns, alternatives can provide uncorrelated appreciation that helps to maintain portfolio stability and growth. The time to consider these strategies is before you need them.
What Are Alternatives and How Do You Use Them?
There are two fundamental ways to make money as an investor: buy a security that increases in value or collect income from owning a security. Traditional stocks and bonds accomplish these objectives through conventional economic exposures.
Alternative strategies can generate returns in different ways. Examples include:
Market-neutral strategies can generate positive returns even if the overall market stagnates, using relative value trades.
Insurance-linked strategies can generate positive returns independently of market or economic performance.
Trend-following strategies can earn positive returns even in declining markets.
Credit strategies that can produce income through periods of rising interest rates.
This is a brief overview of some of the strategies used in our alternative investment allocation. We don’t believe that any single alternative strategy will deliver solid returns in all environments. With that in mind, one approach we use at Pure Financial Advisors combines two diversified strategies that don’t move in tandem. This allocation replaces 5% of both traditional equity and fixed income exposure. These alternative strategies are intended to complement—not replace—traditional low-cost, tax-efficient investments.
Is This Right for Me and My Portfolio?
Alternative investments aren’t suitable for every investor, but they may be particularly useful in today’s environment. These strategies are most appropriate for investors who seek diversification beyond traditional assets and are concerned about the potential for unique economic pressures to impact both stocks and bonds simultaneously.
Our current economic backdrop is rare. Elevated valuations in certain equity segments, potential for inflationary pressures, and concentration risk haven’t been felt by investors in decades. A modest allocation to carefully selected alternative strategies may be an appropriate tool for working through this confluence of market forces.
The most important thing is to plan ahead instead of just reacting to market changes. Before considering any new investment options, take time to think about whether they make sense for your specific situation. Consider your financial goals, how much risk you’re comfortable with, your tax situation, and how alternative investments may complement your existing portfolio.
Next Steps:
- Consider your risk tolerance and your current portfolio to ensure they are in alignment.
- Review your investment holdings and asset classes to see if there are any others that might enhance your portfolio.
- Take a deeper dive into your overall financial situation using our free Financial Blueprint.
