It's a rare day when a hedge fund manager admits he's never heard of an asset type. But that's just what Ray Schuville, a managing director and private client advisor at U.S. Trust, heard from a client earlier this year.

The manager was looking for a way to lower the risk of the large personal stake he had in his own fund. He had been using short-dated Treasuries and cash for that purpose, but was looking for something that could generate income and be "really non-correlating" with his hedge fund, Schuville says.

Schuville and his advisory group teammates, Josh Glazer, private client manager, and George Jenckes, senior portfolio strategist, suggested that the client consider an asset that the team specialized in, an asset that is considered highly alternative even within the alternative space—direct investments in timber and farmland.

The client's response? Crickets.

"There was a blank stare from across the table," Schuville says with a laugh. Jenckes says the client then told the team, "This is the first time I'm hearing of these diversifiers. They're not part of a traditional portfolio."

Up until recently, that was true. But in today's economic environment, ultrahigh net worth clients are increasingly on the prowl for non-correlated assets that not only diversify their portfolios, but can throw off something that looks like a healthy return in this moribund market. Advisors and asset managers are answering the call with a new raft of really alternative assets—assets like timber, farmland, direct consumer and business loans, non-listed REITS and business development companies—some so exotic that their existence may come as a surprise to even a seasoned financial pro like a hedge fund manager.

As diverse as they appear, these investments have some important things in common: they can be lucrative, they are expensive, they are highly illiquid and they are very, very risky. Generally termed "direct investments," this asset class has been around for decades, but investors have recently shown more willingness to embrace the risk for a chance to get at some of those tasty returns. Advisors report that really alternative investments are entering the client conversation in a way, and with a frequency, that they've never seen before.

Pamela DeBolt, a senior analyst at Cerulli Associates, says the firm's research shows a spike in demand for both liquid alternatives (like ETFs and mutual funds which any investor can participate in) and illiquid offerings suitable only to the sophisticated investor able to lock up sums of money for five, seven, or even 15 to 20 years.

The Investment Program Association, a trade group for companies involved in direct investments, reports a 65% increase in sales from the first half of 2012 to the first half of 2013 in illiquid non-traded REITS and BDCs alone. "What's driving it?" asks Kevin M. Hogan, CEO of IPA. "It's almost a perfect storm. Investors are looking for yield in an economy where interest rates are at all-time lows. And people are looking for capital appreciation at a point where the equities markets are already setting record highs."

Buying the Farm
The U.S. Trust team, which has been offering the timber and farmland investments for seven years, has seen interest in this particular alternative investment strategy "more than double" over the last two to three years, Schuville says. To mitigate some of the risk for clients, who must invest at least $5 million for durations averaging around 10-15 years, U.S. Trust takes a very hands-on approach to this asset class.

The investment begins with a crew of local experts scouting for opportunistic deals—"people who know the area, know their industry and know the people," Glazer says. For example, on the farm side, U.S. Trust has 50 people in the field, literally, who have agriculture degrees and often hands-on experience as farmers. For their $5 million investment, investors purchase several geographically diverse farms growing different crops to reduce weather- or disease-related and commodities-price-related risk. The investor enters into a three-year agreement with the farmer. The farmer agrees to pay an annual lease fee, fixed for the first three years (regardless of crop performance). And although the farmer takes all the crop risk (bad harvests, crop insurance, etc.), there are long-term risks that could affect the farmer's ability to pay the lease after year three, like a prolonged drought or a change in U.S. crop-support policy. For timber investments, U.S. Trust has its own specialists manage the timberland to maximize its value.

"When we buy a farm we make sure the farmer leasing it has the funds needed to run it," Schuville says. "We've never had a farmer default on our clients." He adds that part of the goal in these investments, besides the yearly income, is property appreciation, so proper care of the farms and the timber properties is crucial. "We manage the operation going forward, and make sure the farmer is doing everything to keep the farm up to par," he says, with the farmer responsible for day-to-day farming activities.

As Dennis Moon, managing director and head of specialty investments at U.S. Trust notes, "I like to tell people that buying farmland or timberland is like buying gold with a yield." With both farmland and timberland scarce, he expects the underlying value of the properties to rise over time.

There is also an attraction for many investors in being able to touch, feel and in some cases, visit their asset. "We had one investor who lived in New York and Florida," Moon recalls. "He said he wanted to meet the farmer on a farm he'd bought in Missouri. We set up a visit, and he and his wife came out, met the farmer and had a great old time. He told the guy, 'If I can do anything for you, just let me know.' It was very good rapport. We love when that happens."

The hedge fund manager who said he'd never heard of this asset class? He added farms and timberland to his holdings to the point where they have become the primary asset in "that end of the dumbbell" of his investment portfolio, Schuville says.

A New Alt Landscape
Direct investments are just one way that the ultra-wealthy are searching for returns in this slow-growth marketplace. Riskier alternative investments packaged in more traditional forms are also gaining popularity, but these versions have much higher price points and potential returns, and are far less liquid.

Adam Taback, head of alternative strategies for Wells Fargo Private Bank, likes alternative income solutions, including debt strategies, which he says are one of his firm's largest growth areas. The group has raised over $1 billion for these investments over the last 18 months. Among the popular options for investors who are able to tie up their money for two to 10 years are subprime lending—not for houses, but for car loans to people who have "blemishes" on their credit record—and rail car leasing. Increasingly popular too, he says, is European debt. "Europe's banks were slow to get to the point of unloading debt, but that area is now offering private lenders the opportunity to earn as much as 10%-12%," he explains.

Private real estate deals can also be lucrative, Taback says. Properly structured, they can pay a 5%-6% return in income from property leases, and a 10% total return, which includes the profits plus any capital gains on the private real estate.

"The magic for us is we've worked managers across the alternative investment industry to identify strategies that can distribute income as frequently as quarterly," he says. Taback adds that Wells Fargo Private Bank now has nine alternative strategies across hedge funds, private equity and real estate. Some commingled (or bundled) and fund-of-funds strategies can have minimum investments as low as $50,000 and are available for clients who have $1 million in net worth. Other alts may require a $100,000 minimum investment and are available for clients who have at least $5 million in investible assets.

Martin Halbfinger, managing director and private wealth advisor at UBS Wealth Management Americas, prefers alternatives that offer protection against the downside of the current market or at least "more protection than you have with your long investments on the bond side," he says. "It's hedging. You're giving up something while markets are going straight up to protect yourself on the downside."

Halbfinger favors what he calls "event-driven" equity investments, like hedge funds that "use some idea like a catalyst of change in a company" in making their investments. "More companies are buying other companies," he says, so you have arbitrage or spinoffs where the pieces are worth more than the original entity." He also likes "opportunistic credit," preferring investing in bank loans over buying corporate debt. Another area Halbfinger favors for clients seeking alternative strategies is private equity, particularly in distressed real estate and commercial-backed loans, such as portfolios being sold off by banks seeking to raise capital.

"This is all for sophisticated clients, but you still really have to talk about the pitfalls of these investments," Halb- finger says. "Sometime people focus too much on things like historical return. More important is understanding your client's sophistication, risk tolerance and need for liquidity. And they need to know the downside."

Chris Butler, vice president of private client group investment products at Raymond James, likes middle-market lending as an alternative way of generating higher income. "Essentially these are private equity firms with very credentialed managers" who are holding a 40%-50% equity stake in the company, he says. The investor becomes a senior lender. Income can be in the 7%-10% range, he adds, with credit risk minimized by the senior status of the debt and the private equity firm's equity position in the company.

Another option, non-listed REITS, must pass through 90% of their profit to keep their REIT tax status. They also offer distributions in the 5%-7% range, which have no direct or indirect correlation with corporate bond yields, the IPA's Hogan says. Expenses range from 10%-12%, paid up front. When amortized over the typical holding period (five to seven years), however, they are in line with other financial products held for the same time.

"Are there risks?" Hogan asks. "Certainly real estate can be risky, but REITs are not like stocks, and they don't follow the equity market."

BDCs, meanwhile, provide debt or capital formation equity to small- and mid-sized companies, Hogan says. Like non-listed REITs, BDCs also pass through at least 90% of their annual income to shareholders to maintain their tax status as registered investment companies. Portfolios are valued quarterly, and leverage is limited to 50% of the portfolio's assets. Also like nonlisted REITS, BDCs have historically exhibited low correlation with traditional asset classes. A BDC typically requires a five- to eight-year holding period and ends with a liquidation.

Building the Really ALT Portfolio
Smaller investors who get into alternatives typically are advised to keep such holdings fairly limited—usually about 5% of a portfolio. But in the case of wealthier investors, who can afford to take bigger risks in hopes of gaining bigger rewards, the amount of a portfolio placed into alternatives can be substantially greater—in many cases upwards of 15%. That's a big enough percentage to really make a difference in overall return if the assets do as well as hoped—and to create a lot of investor pain if they fail.

"You can go out beyond 20% [of a client's portfolio invested in alts]," Butler says. "But you need to consider the individual circumstances carefully. Even for high net worth individuals, it may not be smart to over-extend. It's important that clients understand the terms of illiquid offerings. Lock-up periods of eight to 12 years are not uncommon." He also recommends limiting concentration for any particular alternative investment product to no more than 3%-5% of assets.

When considering illiquid strategies like private equity and opportunistic real estate, Butler looks for returns that can outperform the market by a 5%-7% spread. "Clients need to be compensated for the fact that they won't have access to their capital for an extended period of time," he says.

His team looks at about 300 opportunities a year, with a narrowed group of selections reviewed by a panel of 10 senior executives. Among alternative investments that his group likes are tactical funds of hedge funds that can allocate a larger portion of their capital to higher conviction strategies and managers. "We like managers who have maybe 50% of their portfolio focused on a specific opportunity—for example mortgage-backed securities," he says, where the manager may have special expertise.

While alternative investments are certainly hot these days, Cerulli's DeBolt offers one final word of caution in addition to all the others—those who are expecting alternatives to protect their assets in the event of an equities slide could be in for a surprise. "We really haven't been through a down market now since 2008, to see if all these alternative investments will do what they're supposed to do," she says.