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Why we use "alternative" investments

When Anchor Financial Group was founded in 1989, the universe of investment products consisted mostly of stocks, bonds and cash in one form or another.  This included mutual funds and annuities.  Later exchange traded funds (ETFs) arrived, but they were just a different form of the same investments – stocks, bonds & cash.

A decade ago this started to concern us. In general, our clients who wanted higher growth had more stocks, and those who wanted more safety had more bonds. Interest rates were low by historical standards, meaning they likely would rise in the future. Rising interest rates reduce the profits in bonds. So our more conservative clients could load up on bonds and be safe, but what was their profit potential going forward? And stocks, while they can generate fantastic returns at times, involve a lot of risk and require a very long-term horizon. It seemed like we had stool with only 2 legs, and there ought to be a third leg.

About this time we started researching “alternative” investments, which are investments that tend to NOT correlate with the stock and bond markets. Large endowment funds for universities like Yale, Harvard and Princeton had been using alternatives in their portfolios for years, and with great success. Yale’s 2007 endowment report contained the following:

Over the past two decades, Yale reduced dramatically the Endowment’s dependence on domestic marketable securities by reallocating assets to nontraditional asset classes. In 1987, nearly 80 percent of the Endowment was committed to U.S. stocks, bonds, and cash. Today, target allocations call for 15 percent in domestic marketable securities, while the diversifying assets of foreign equity, private equity, absolute return strategies, and real assets dominate the Endowment, representing 85 percent of the target portfolio. The Endowment’s long time horizon is well suited to exploiting illiquid, less efficient markets such as venture capital, leveraged buyouts, oil and gas, timber, and real estate.

While the average investor still could not participate in all of the investments that Yale could (like buying forests!), there were a growing list of similar investments that they could. One was non-publicly traded real estate investment trusts REITs), which allowed investors access to all types of commercial real estate investments and debt. Another was Business Development Companies (BDCs), where investors could pool their funds and lend money to private middle market ($100 million to $1 billion valuation range) companies Since these weren’t traded like stocks and bonds, they were not subject to the constant volatility of the markets.

In 2007 we started investing some of our clients’ money in alternatives. Since then we have used REITS, BDC's, Energy Fund's, Interval Funds and Mortgage pools. I won’t go into detail on all of them, but they all are generally non-traded or less-frequently traded, and have little to no correlation with the stock and bond markets. This has increased diversification and decreased volatility for our clients. This was the third leg of the stool we were looking for.

Even today, most advisors are reluctant to provide these alternative investments to their clients. Why?  First, they involve a lot more research than just picking stock and bond investments – which means increased overhead costs. Second, the vast majority of advisers who do offer alternatives do so on a commission basis, which typically pays them a 5%-7% up-front commission – most of which comes out of the investor’s pocket. At AFG we do not collect commissions on these alternatives; instead the commission is credited back to the investor’s account. AFG charges only the same ongoing low management fee that we charge on all of our investments.

We have been asked more than once by investors why we would give up so much money (commissions). After all, in many cases it will take years for us to make the same amount of money on these investments as a commission-broker will make immediately. The answer is that it reduces our marketing costs. Commission-based brokers have to spend a lot more money in marketing to attract new clients to replace the dissatisfied ones who leave them. We’d rather just keep our clients happy so they don’t leave us in the first place.