In the first of two articles looking at the growing use by HNW, affluent and even retail investors of what are loosely dubbed alternative assets, we note a level of skepticism that is becoming more evident about this trend.

There’s a strange convergence going on in the alternatives market.

Investor interest in hedge funds, venture capital, private equity, private credit, real estate and other non-publicly traded vehicles has never been higher, and Wall Street’s major domo asset managers are rapidly rolling out – and aggressively promoting – alternative products. (Even hedge funds are getting into the act, as this article shows.)

Private market assets in the US totaled $14.8 trillion in 2024, according to McKinsey & Co, and have grown at close to 20 per cent a year since 2018. In just 30 months, the total market for semi-liquid funds has surged 60 per cent to about $350 billion, while net assets in private credit leaped an astonishing 151 per cent to over $188 billion in two years, according to a new Morningstar report. A full quarter of retail investors now have private equity investments, a number that rises to 35 per cent for investors with over $500,000 in investible assets.

Giant firms like Apollo Global Management, BlackRock, Blackstone, Capital Group, KKR, State Street and Vanguard are all furiously clamoring to get on the alternative bandwagon. Morgan Stanley is pushing alternatives big time, as CEO Ted Pick argues that financial advisors remain “underweight” in alternative allocation. Even conservative Fidelity Investments is adding alts to its custom model portfolios.

At the same time, returns from private market funds have never been lower and scrutiny and skepticism surrounding the asset class is mounting.

Returns, risks and costs questioned
State Street’s private equity index, which tracks returns from private equity, private debt and venture capital funds, recorded a 7.08 per cent return last year, compared with a 25 per cent total return for the S&P 500 index, which also outperformed private funds on a three, five and 10-year basis.

Moody’s Ratings has just released a report warning about the risks that come with selling private equity and private debt funds to individual investors. A new study published in the Journal of Portfolio Management entitled “The Demise of Alternative Investments” argues that alts “cost way too much for what you get.”

Morningstar steps up
Not coincidentally, Morningstar is stepping up its coverage of the sector. In a keynote address yesterday at the data analytics company’s annual Investment Conference in Chicago, chief executive officer Kunal Kapoor called the convergence of public and private markets “a snowball coming down the hill.”

Noting that private markets “come with higher fees, less transparency, less liquidity and more complexity,” Kapoor said Morningstar would expand its analysis of the market to help investors determine whether they are “going to give up liquidity and pay more; is expected outperformance worth it?"

Morningstar also unveiled a new report on semi-liquid funds that give retail investors access to private markets, including interval funds and nontraded real estate investment trusts (REITs). While private funds have risen in prominence, “definitions, data and transparency have lagged behind the headlines,” maintained Morningstar analyst Jason Kephart. “[Private funds] promise greater access and returns, but also bring steep fees, heavy use of leverage and liquidity limits that investors must carefully evaluate.”

Those concerns were echoed by Dan Wiener, the former CEO and current board member of RWA Wealth Partners. “Promotions for alternatives promise so much more than what the reality is, it’s not even funny,” Wiener said. “They’re designed to attract investors to products they have no business investing in.”

High fees
Fees for private market funds can be up to three times higher than those for public markets, according to Morningstar. The average annual expense ratio for semi-liquid funds is 3.16 per cent, according to Morningstar, while the comparable figure for active mutual and exchange-traded funds is 0.79 per cent.

In addition, commissions for selling alternative funds, often 2 to 5 per cent, can sometimes exceed 10 per cent.

Private funds tout their so-called “illiquidity premium,” but a recent report by asset manager Amundi and Create Research cited high fees and commissions, as well as an opaque investment process and record high levels of “dry powder,” sums allocated but not yet invested. As a result, the report warned, huge inflows into alternatives could dilute returns.

Retail concern
Wiener, who edited The Independent Adviser for Vanguard Investors for over 30 years, is particularly concerned about the impact alternatives will have on investors with less than $5 million, excluding their house. In addition to liquidity lockups and high expenses, Wiener worries that smaller investors may not have access to the industry’s top quartile managers. 

What’s more, retail investors are being targeted by what Wiener calls “the alternatives tidal wave headed towards the shores of the retirement universe. Individual retirement accounts are the pot of gold Wall Street is looking at. They want to get into 401(k)s, sit back and mint money. For investors it will be like the Roach Motel – once you’re in you can’t get out.”

Target date funds targeted?
Private funds have their sights set on target date funds (TDFs), according to certified financial analyst Tim McGlinn, founder of “The Alternative View” website. TDFs are “the most coveted spot in the 401(k) world,” McGlinn said, because of their huge size (over $3.5 trillion) and fast growth, having quadrupled in size in 10 years. 

Fees are relatively low however, but if 10 per cent of stocks in TDF portfolios were replaced by alternatives, expense ratios would nearly double, according to research cited by McGlinn. “The most pernicious risk might be individuals with model portfolios that include alternative investments whose performance isn’t even noticed,” he cautioned. “The compounding effect could lead to them being far worse off.”

To be sure, private fund managers can point to a premium that still exists for having investments tied up for long periods of time and a lower correlation to public market volatility. And some sector-focused private funds, such as those focused on finance and energy, have been able to outperform public market sector peers, according to State Street.

Push from Wall Street and Washington
And make no mistake, Wall Street’s push is just beginning. BlackRock CEO Larry Fink has said that 20 per cent of portfolios may be allocated to private assets in the future. Currently, alternative investments such as private credit or private equity are only weighted at 5 per cent in mainstream allocation models, according to Morgan Stanleys’ Pick. 

The “right level” may be between 10 per cent and 15 per cent or more allocated to alternatives, the CEO told a company conference earlier this month. “That means that today we are structurally underweight in the system of $250 billion to $500 billion in alts.”

The Trump administration and Republicans in Congress are expected to accelerate the private markets momentum.

The US House of Representatives passed a bill this week that directs the Securities and Exchange Commission to expand the eligibility requirements for participating directly in private investments. 

Currently “accredited investors” must have $1 million in net worth, excluding their primary residence or an annual income of $200,000, and $300,000 in income for joint spousal investors. To broaden access to private markets, the new legislation would expand the definition of an accredited investor under what is known as Regulation D to include people with professional-level knowledge through either  their work experience or education, which would explicitly include registered brokers and investment advisors.

A multibillion-dollar tax break for private credit funds is also being proposed, which would limit taxes on dividends paid to investors in so-called business development companies, one of the primary investment vehicles utilized by the private credit industry.

Wiener has no doubt that lawmakers will loosen regulations. “It’s set in stone,” he said.

Part two of our alternative coverage will examine how family offices and UHNW investors are approaching the controversial asset class. Please email the editor if you have comments and responses. tom.burroughes@wealthbriefing.com