Advisors who are working with high-net-worth clients will likely be asked at some point to offer guidance about alternative investments.

Whether it is a hedge fund, real estate or a racehorse, it is important for advisors to know not only the upside potential of such activity but also the particular risks and vulnerabilities.

Some investments are harder to advise on than others — think of rare coins and art — but advisors can distinguish themselves.

CAVEAT EMPTOR
It is important to help clients verify the credibility of an investment’s source.

Look no further than the headlines about forgeries of fine art to know the truth of the adage “All that glitters is not gold.”

Even established specialists such as Sotheby’s get taken in, as recently as 2011, to the tune of $10 million for a fake portrait supposedly by Frans Hals, a 17th-century Dutch master.

Additionally, many alternative investments exist in an essentially unregulated environment, adding to the need for advisors and investors to thoroughly understand what they are paying for.

They are also typically illiquid, and many types feature high minimum investment requirements. Some come with steep fee structures that make getting in an expensive proposition.

DIVERSIFICATION, HEDGING AND TAXES
But one advantage of alternative investments arises from some of these disadvantages.

Because of their lack of correlation with many asset types associated with traditional investments, they can provide a hedge against certain types of risks in other classes of assets.

This, of course, is what is touted on the financial networks by those hawking gold and silver. Such assets are negatively correlated with the performance of stocks and bonds, and they also provide a classic inflation hedge.

Similar claims could be made for certain collectibles, selected types of real estate and certain commodities contracts.

Despite their typically high front-end fees, alternative investments often come with lower transaction costs, because of lower turnover.

In addition, because of their lower liquidity, it is usually best to view alternative investments with a longer time horizon.

Profits on sales of holdings owned longer than 12 months are taxed at the capital gains rate, rather than as ordinary income. This is usually an advantage for investors in higher marginal tax brackets.

Advisors with clients who are foreign nationals or domestic tax-exempt organizations should note that certain types of private-equity partnerships can subject investors to effectively connected income from actively managed businesses or trades within the private-equity portfolio.

Similarly, tax-exempt entities investing in alternative assets should exercise caution that they do not subject themselves to unrelated business income tax. Internal Revenue Service Publication 598 contains additional information on how tax-exempt groups may avoid such complications.

It is also possible to hold certain types of alternative investments in self-directed individual retirement accounts and 401(k)s, though we do not typically recommend making them a cornerstone of anyone’s retirement account.

Internal Revenue Code 408(m) specifies the types and forms of precious metals, for example, that may be held in retirement accounts, along with the custodial method that must be used. Typically, an approved trustee must maintain physical possession of the coins or bullion.

PRACTICAL CONCERNS
So, what should an advisor do if a client asks what she should do with the paintings she inherited from her father’s estate?

What is the best way to get a reliable valuation for the artwork? Where is the best place to turn if the paintings will be sold?

A website such as ArtBusiness.com could provide a preliminary idea, but it would be far better to cultivate a relationship with a reliable, knowledgeable art dealer or appraiser.

Try reaching out to the Appraisers Association of America, which is one of the most respected trade organizations for those specializing in fine and decorative arts (appraiserassociation.org). A qualified professional may charge a fee to perform the appraisal, but the results should be worth it.

Many HNW individuals like to own actual gold or silver as a hedge against inflation or even more desperate circumstances.

What steps should advisors take to help them make their transactions as secure as possible? The most important step is to deal only with a reputable precious metals dealer who has been thoroughly vetted.

HOLDING PRECIOUS METALS
When we have a client who wants to take physical possession of precious metals, we counsel them to have the assets shipped to our offices, and we have developed procedures for accepting the delivery.

We then ask our clients to join us there for the opening of the package. This gives our clients absolute assurance that what they ordered is what they are receiving.

We have also developed a list of security measures that we recommend to clients, including ideas for safe storage, actions to take in the event of a home invasion and other considerations.

Overall, we do not make alternative investments a focus of our work with clients, and for most advisors working with individuals or even small institutional clients this is likely to be the case.

Although some large institutional funds have begun allocating a small portion of their portfolios to alternative investments — typically less than 10% — it is not something we would recommend to many of our clients.

However, a client in a special situation may, from time to time, ask for advice or help. When that happens, advisors should do their homework, reach out to trusted professionals, carefully evaluate all the fees and help the client ask the right questions.

This story is part of a 30-30 series on building a better portfolio. This story was originally published on July 14.

Kimberly Foss

Kimberly Foss

Kimberly Foss, CFP, CPWA, is a Financial Planning columnist and founder of Empyrion Wealth Management in California and New York. She’s also the New York Times best-selling author of Wealth by Design. Follow her on Twitter at @KimberlyFossCFP.