The Benefits of Alternatives in an IRA

By: Gridline Team | Published: 08/25/2022
Est. Reading Time:
4 minutes

The goal of retirement investing is to preserve and grow your wealth to maintain your lifestyle in retirement. Since public markets are struck by recessions every six years, on average, investors need to diversify their portfolios to reduce risk.

Risks are associated with over-concentrating your portfolio on any asset class, sector, or region. Doing so exposes you to greater market volatility and the potential for larger losses. 

For example, during the COVID-19 market crash, Canada's ten biggest pension funds lost an estimated $104 billion due to an over-concentration in public equities. Individuals nearing retirement age are especially vulnerable to such losses, as they have less time to recoup their losses.

Investing in alternative assets, like private equity and hedge funds, can help diversify your portfolio and protect you from the ups and downs of the stock market. IRAs, or individual retirement accounts, are investment accounts that offer tax benefits to encourage savings for retirement. Investing in alternatives through an IRA is a powerful way to grow your wealth while taking advantage of the tax benefits.

The risks of retirement portfolio over-concentration

Investors and investment advisors alike face significant risks when over-concentrating a portfolio.

Investment advisors have a fiduciary duty to their clients, which includes the duty to diversify. As the law firm Lubiner, Schmidt & Palumbo explains, "an allegation of overconcentration against a broker connects to Suitability and FINRA Rule 2111, and is considered a violation of the rule, as well as a breach of a broker's fiduciary duty." 

These aren't just empty words: the NYSE found that one representative "recommended and effected unsuitable transactions that resulted in high concentrations of technology sector unit investment trusts," resulting in a censure and a 10-year suspension.

Over-concentration can pose a significant risk to an investor's financial security. Financial adviser Hannah Szarszewski warns that "what I see regularly is an over-concentration in the technology sector." While the tech industry led the charge after the pandemic, it has since suffered catastrophic losses, even with a recent bull run. For instance, the ARKK innovation ETF is still down over 60% from its all-time highs.

Diversifying an IRA with alternatives

One way to diversify your retirement portfolio is to invest in alternative assets through an IRA.

An IRA allows you to contribute to an investment plan pre-tax, up to a certain amount each year. Traditionally, IRAs have been invested in stocks, bonds, and mutual funds. However, the IRS now permits a wider range of investments, including cryptocurrencies, hedge funds, and private equity.

Diversifying with alternatives is a good strategy in any market condition, but it is especially important during periods of market volatility. For instance, during both the dot-com crash of 2000 and the global financial crisis of 2008, private equity funds had a less significant drawdown and quicker recovery than public markets. Further, while 40% of stocks experienced catastrophic loss in a recession, only 2.8% of buyout funds did.

Considering that current retirees have experienced 5-10+ recessions over their adult lifetime, it's clear that diversifying your portfolio with alternatives is a smart move. The lifetime benefits of an alternative investment strategy are especially clear when compared to the potential losses from an over-concentrated portfolio.

Not only that, but the outperformance of private markets extends beyond just recessions. For example, in the ten years following the dot-com crash, private equity maintained a 7.5% average, compared to just 0.08% for the PME index.

More recently, private equity has again outperformed public markets. A study by Hamilton Lane shows that since 2017, private equity funds generated an extra 83 cents per dollar invested.

The next generation of retirement investors

Millennials today are extremely forward-thinking when it comes to their finances. Nearly 90% of them have some kind of retirement plan, compared to just 73% of baby boomers at their age. They're also putting away around twice as much as boomers.

Young people also know that traditional investments make "dismal" returns, and nearly 75% of millennials plan to use an alternative investment approach in the next five years.

Even Gen Z is getting in on the action: a poll of 2,000 UK investors found that 62% of Gen Zers have invested in alternatives. In less than a decade, Gen Z incomes are expected to surpass those of millennials, making them an increasingly important demographic for the industry.

That said, older investors shouldn't feel left out. Many boomers are already investing in alternatives, and 60% of those over 65 want to see mainstream crypto adoption. Boomers also dominate real estate: They have owned the most non-commercial real estate since 2001. 

IRAs offer a great way to diversify your portfolio with alternative assets. With the tax benefits, they provide a powerful tool for retirement planning. For the next generation of retirement investors, investing in alternatives through an IRA is a smart move.

Diversified IRA investing done right

While private markets have outperformed public markets, an institutional-grade investment strategy is still important. One key reason is that private markets have a much larger dispersion of returns, so selecting the wrong manager could cause significant underperformance.

For individuals, one of the best ways to access private markets is through a fund of funds, which invests in various VC funds to reduce risk. This strategy provides the diversification individuals need to reduce risk while providing the potential for strong returns. As an NBER study showed, VC fund of funds, too, consistently outperform the S&P 500 and Russell 2000 PMEs.

Diversified private market portfolios outperform public markets and can achieve return dispersion, a measure of risk similar to traditional investment portfolios. 

Regardless of the funds selected, a long-term investment horizon is crucial. This is true in public markets and even more so in private markets, where there is often a lack of liquidity. In addition, investment funds often follow a "J-curve," meaning that returns may be negative in the early years and then improve as the fund matures.

Accessing private market opportunities, however, can be difficult for individuals. For one, minimum committed investment amounts can reach $25 million or more. Further, the number of investors in a fund is often constrained to between 10 and 20. And of course, the process of due diligence is time-consuming and resource-intensive.

Gridline solves these problems by providing a curated selection of professionally managed alternative investment funds and enabling access for individual investors and their advisors to gain diversified exposure to non-public assets with lower capital minimums, lower fees, and greater liquidity.

Gridline is the Vanguard of alts, making diversified investing in private markets as easy as investing in an index fund. For retirement investors looking to diversify their portfolios, Gridline is the solution.

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