If you are working with high-net-worth clients, it’s likely that at some point you will be asked to offer guidance about alternative investments. Whether it’s a hedge fund, real estate or a racehorse, it’s important for advisers 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 if you can, you distinguish yourself.

CAVEAT EMPTOR
It’s important to help your client verify the credibility of the investment’s source.

You need 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 advisers 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 actually 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 you will see 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.

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Alternative investments’ lack of correlation with many traditional investments means they may provide a hedge against the risks inherent in other asset classes.

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.

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

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Although they may carry high front-end fees, alternative investments often come with lower transaction costs.

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

One can only hope that this year will see a return to a more normal mortgage market. Image: Fotolia
Racehorses are one example of a hard-to-manage alternative asset.

It is also possible to hold certain types of alternative investments in self-directed IRAs and 401(k)s, though we do not typically recommend making them a cornerstone of anyone’s retirement account. IRC 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 would you do if a client approached you to ask what she should do with the paintings she inherited from her father’s estate? How would you go about getting a reliable valuation for the artwork? Where would you turn if you determine with your client that the paintings should be sold?

You might go to a website such as ArtBusiness.com to get a preliminary idea, but it would be far better to cultivate a relationship with a reliable, knowledgeable art dealer or appraiser. You might wish to reach out to the Appraisers Association of America, which is one of the most respected trade organizations for those specializing in fine and decorative arts (www.appraiserassociation.org). A qualified professional may charge a fee to perform the appraisal, but you and your client are much more likely to be able to have confidence in the results.

Many HNW individuals like to own actual gold or silver as a hedge against inflation or even more desperate circumstances. If you are working with such clients, what steps would you 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 whom you have 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 actually developed procedures for accepting the delivery.

detail of piles of coins isolated
Sometimes clients want to invest in coins. When they do, adviser Kimberly Foss takes delivery at her office.

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.

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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.

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

While 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 your advice or help. When that happens, do your homework, reach out to trusted professionals, carefully evaluate all the fees and help your client ask the right questions.

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.