Alternative investments – typically those outside public capital markets and traditional fixed-income – are gaining traction with high net-worth (HNW) clients as interest rates remain stubbornly low and top-quality stocks increasingly come with top prices. Yet, while these specialized products can provide positive returns for clients who can make the minimum investment threshold and who can afford the products’ costs and lack of flexibility, you must emphasize the risks associated with these investments.

“We go back to the basics [with clients] and say that there is no free lunch on these things,” says Ian Robertson, vice president, director and portfolio manager with Vancouver-based Odlum Brown Ltd.

Once your clients have decided they would like to explore alternative investments, the options are as diverse as complex private debt, infrastructure financing and high-risk investment in emerging industries. At the same time, some tried-and-true alternative choices that are relatively easy to understand, such as real estate, are rising in popularity, as many clients see the value in their homes rise.

“Private debt, real estate, mortgage investment corporation – I would say it’s Alternative 2.0,” says Francis Sabourin, director, wealth management, and portfolio manager in Montreal with Toronto-based Richardson GMP Ltd.

Other alternative investments that are getting a closer look from HNW clients include private equity, venture capital and market-neutral strategies often associated with hedge funds. Still, many advisors suggest that setting portfolio limits for alternative investments as a whole is prudent. Sabourin, for example, manages five portfolios. They include traditional fixed-income and equities, but may have allocations to alternative investments of 15%-30%.

Toronto-based Assante Private Client, a division of CI Private Counsel LP, on the other hand, has allocation limits of up to 10% for each alternative investment strategy, up to a maximum of 20% within a client’s overall portfolio.

When introducing your HNW clients to these products, it’s crucial to ensure clients appreciate both the risks and illiquidity that often accompany alternative investments, which can lack the regulatory oversight of public markets. When these investments lose value, for example, they are not necessarily easy to exit. On the other hand, they may provide welcome growth when more traditional investment vehicles are performing poorly.

“Inevitably, there are going to be certain periods of weaker performance – possibly negative performance – and if clients don’t understand that strategy, then they’re less likely to stick with it,” says Peter Filippakis, an investment counsellor in Montreal with Assante Private Client. “If they understand it, they’re more likely to be patient and ride the investment out.”

Alternative investments also can be difficult to track. For example, investments in real estate or timber markets may be difficult to value from one day to the next – a reality that may take getting used to for clients accustomed to the minute-by-minute valuations available in public markets. “People will say, ‘Well, what’s my private debt doing today?'” says Sabourin. “I say, ‘I don’t know. We’ll see at the end of the month’.”

Another liquidity risk relates to lockup and notice periods. The “lockup” period is the fixed amount of time an investor may be required to leave his or her cash in an investment. The “notice” period is the time an investor must provide to a portfolio manager before the investor can access his or her funds once a lockup period is over. “Both of these things mean that an investor may not be able to get access to their capital when they actually want it,” says Filippakis.

A range of other disadvantages also need to be reviewed with clients. These include: redemption caps, which allow a portfolio manager to suspend redemptions or redeem only a portion of the requested funds if market conditions are unfavourable; leverage (while borrowing to invest can yield strong returns, it also can carry a high degree of risk and clients should be aware that leverage has the capacity to magnify losses); and the costs of these investments, which potentially can take a significant bite out of an investment’s growth. “We want to look behind [the diversification offered by alternatives],” notes Robertson, “and say, ‘Is there a genuine benefit to your portfolio at the end of the day?'”

With so many potential risks, due diligence is a crucial part of the process when considering whether to add an alternative investment to a client’s portfolio. Getting to know the investment manager is particularly important, says Filippakis: “The financial advisor should really go through the offering memorandum and really interview the investment manager before turning over their client’s money.”