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Many IFAs are concerned about using directly held esoteric or alternative investments in their clients’ portfolios. They are regarded as unconventional and the investment structures are often not regulated and their promotion may be outside the scope of the FSA.

However, a case can be made for recommending esoteric investments if we look closer at two of the key assumptions conventional retirement planning is based upon – asset allocation and the level of returns we are forecasting.

By esoteric investments, I am not referring to any form of collective investment scheme, be it regulated or unregulated. I am referring to directly held assets, non-regulated investments into farmland, forestry, gold and other precious metals, property and other tangible assets.
Asset Allocation
A conventional asset allocation for a client, depending upon their risk profile, might look something like this:

Risk Profile: Low Med High

Equities 30% 50% 70%

Bonds 45% 30% 15%

Cash 15% 10% 5%

Commodities 10% 10% 10%

However, this model ignores three important risks:

• Bonds are subject to credit risk (even sovereign bonds as investors in Greece are now discovering).

• Inflation can erode the value of bonds.

• Inflation can erode the value of cash.

So even our low risk investor has been exposed to these potential hazards.

The other issue here is that the majority, if not all of the portfolio, will be allocated to funds and held with financial institutions. This means that investors are also exposed to the risk of these funds or institutions failing (counter-party risk).

With the sovereign debt crisis rumbling on, interest rates at historic lows, billions being pumped into the global economy and growth slowing there is a sense that these risks are still pertinent considerations.

Level Of Return
Much retirement planning is often based on achieving an annual compound return of 7%. If we assume 3% for inflation and costs of 1.5% (management fees, trading fees, wrap fees) this means we need a total return of about 11.5% a year.

Is this possible? Well, we would expect the highest returns to come from equities as the riskiest assets within a portfolio. However, the gross return including dividends for the ten years to 31 December 2011 on the MSCI United Kingdom index was just 4.12%.

The returns are similar for other developed markets and only investors who are prepared to venture into the emerging markets such as India and China see double digit returns for the same period. And this is just for the portion of the portfolio that is allocated to equities.

According to Andrew Lapthorne, Societe Generale’s quantative analyst, the implied yield on a traditional balanced portfolio comprising a mix of bonds, equity and cash is now below 3% per annum. So if a return of 11.5% a year is at best optimistic and at worst unlikely, investors planning for retirement have to change some of the other assumptions in their model:

• Work for longer

• Increase their contributions

• Earn higher returns

Esoteric investments – the good

So bearing the points above in mind, there is a case for some esoteric investments to form part of a portfolio:

• Directly held tangible assets can provide a strong hedge against inflation and bond market defaults – something tangible always retains some value and minimises counter-party risk.

• Esoteric investments are also a useful diversification tool as they are uncorrelated to the wider markets and so can provide some protection against further market volatility.

• Well-structured esoteric investments can also have a lower total expense ratio (TER)

• Esoteric investments offer potentially high returns and often offer defined returns – getting investors closer to the level of returns they need in order to achieve their objectives

Esoteric Investments – The Bad
However, it is this quest for returns that I feel often leads investors into poor asset allocation decisions. Excited or tempted by the prospect of high returns, they naively over-allocate to esoteric investments.

They can then find themselves over-exposed to unconventional, unregulated investments that leave their financial planning in tatters if they fail. They are also exposed to liquidity risk, as directly held investments are of course much less liquid then conventional investments.

Esoteric Investments – The Ugly
And investors’ understandable desire for high returns is not helped by unscrupulous advisers and product providers taking advantage of the non-regulated status of some esoteric investments.

In this corner of the market many products are quickly put together, opportunistic projects designed to take advantage of the latest fads in the investment world. Much of the marketing material is heavy on the benefits and light on the associated risks of the investment and many of the people promoting these opportunities are non-regulated, commission hungry advisers who are driven by the need to achieve sales rather than provide good advice, products and service.

The Adviser Role
I think the bad side of esoteric investments can lead advisers into the trap of ignoring the whole sector, but as outlined above, there are good reasons to consider using esoteric investments in retirement planning for certain clients.

Many investors are disappointed with the current market volatility and will already be interested in an alternative to conventional assets – but the role of the adviser is more important than ever when it comes to esoteric investments. They are harder to value and assess and there are more pitfalls to navigate.

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