The crucial considerations when switching clients into alternatives

Two commentators have shared why the inclusion of alternatives in a diversified portfolio shouldn’t be a simple switch with a traditional asset and will depend heavily on clients’ objectives. 

The convergence of equities and bonds has reduced the benefits of diversification in recent months, with advisers finding themselves forced to consider uncorrelated or low-correlated assets, or alternative strategies. 

“Portfolio allocations are increasingly leaning on alternative investment strategies to diversify exposure beyond a more typical equity/bond mix. These strategies include private credit, infrastructure and hedge funds, which can help reduce reliance on traditional equity/bond mixes. 

“But that brings a new set of challenges for advisers. They may introduce new risks, such as liquidity constraints, complexity or valuation challenges,” Mercer said in its Top Investment Considerations for Financial Advisers 2025 report. 

But given the risks such as liquidity mismatches, valuation difficulties and unpredictable returns, thanks to their use of derivatives and synthetic instruments, advisers are urged to proceed with caution before changing up their allocations.

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Rebecca Jacques, head of wealth management investment solutions at Mercer, said: “You can’t just switch out high yield strategies or multi-asset credit for private debt. What is the goal of fixed income in that portfolio? If it’s downside protection, liquid alts might be a better strategy. If it’s diversification with alpha, perhaps the credit spectrum is more suitable.”

Appearing on an IMAP webinar, Frank Danieli, head of credit investments and lending at MA Financial, said alternatives shouldn’t necessarily be isolated in their own “bucket” within a portfolio. 

“Alternatives are a really broad description. What it shouldn’t mean is that you are allocating into something that is higher risk. It should mean you are substituting one thing for another that has a different characteristic, and there will be benefits and trade-offs to that.

“It’s not one bucket. It’s a type of asset class that can deliver a substitution for defensiveness or growth in the right mix.

“So in a defensive portfolio, you think about the bonds component of a 60/40 portfolio. If you substitute bonds with private credit, then what are you talking about? You shouldn’t be changing the fundamental nature of what you do. A bond is a loan to a company and private loan should be a loan, too. It’s going to be less liquid, and you trade off some liquidity by investing in private credit.”

Mercer stated three considerations when considering alternatives allocations for diversification should be:

• What does genuine diversification look like?
• What does diversification really cost?
• Is the portfolio at risk of compounding risks through exposure?

Earlier this week, Money Management covered how financial advisers are assessing red flags in private markets funds and those which can deter them from making an investment. These include related party risk, conflicts of interests, managers who had closed funds previously, and differences in their net asset values. 

Kieran Berry, chief executive and managing director at River X, said: “The one thing where we are really worried is anything with related party risk in illiquid assets. If we get a sniff that there’s a lot of concentration risk in a portfolio or related party interest, then that is a conflict and we will back away from those opportunities. 

“If it feels like there’s a conflict, there’s enough choice in the market for us to go elsewhere.”