To select among individual investments, whether conventional or alternative, you need to evaluate the specific merits of each and filter down to one that makes sense for you. This process is especially important when choosing alternative investments, which are among the most complicated asset classes in modern investing. Proper selection requires research, due diligence and significant amounts of caution.
Be Aware Of Alternative Investments’ Five Challenges
Let’s review the five greatest challenges alternative investments present to investors.
1. Lack of transparent information on the investment strategy
The information on alternative investments is not transparent: each fund or investment interest keeps information very closely guarded so that other alternative investment or hedge fund managers do not use it to benefit themselves or to trade against their competitors. Most offering memoranda produce documents that range from 80 to 200 pages. Each is vague on specific details of the investment strategy while outlining all of the ways the investment may fail and limiting the offering entity’s liability should the investment strategy fail.
2. Lack of regulatory oversight
Much of the alternative investment universe is either thinly regulated or virtually unregulated. Historically, government regulators only allowed the wealthy to invest in most forms of alternative investments for two reasons: the wealthy were by definition sophisticated and therefore would have their attorneys and accountants review each deal and provide their own due diligence; they could also afford to lose money without undue suffering. The regulators set very specific “accredited investor” guidelines. Fortunately or unfortunately, most attorneys who have been in practice for 10+ years now qualify as accredited investors based on their income and their total net worth.
This might be viewed as unfortunate because the original “accredited investor” guidelines were not indexed for inflation. As my revered grandmother once said, “A million dollars is not what it used to be.” “Wealth inflation” allows many attorneys to “play” in an area once reserved for the ultra affluent. While this is good because it gives us all many investment options, it’s important to remember that the alternative investment area is also one of the riskiest and least regulated.
3. The broad nature of the definition of “alternative investment”
By its very title as an asset class, an “alternative investment” is anything other than a “conventional” stock, bond or mutual fund. It is very easy to get lost in the complexity of this world. Most investors begin to focus on a specific subset of alternative investments if for no other reason than to whittle down the options from which to select.
4. The high fees and high minimums inherent in the nature of alternative investments
Because of the individual nature of alternative investments, they often require more employees to execute strategy. For example, you may need a group of business experts who research problems in the market segment, and desks of currency traders. Annual fees can range from up to 2-5% of the assets, on top of which are success fees that can range from 20-50% of the growth of the investment annually or upon distribution. Minimum investments can also be high, ranging from $250,000 to $5,000,000 per investor.
5. Illiquid Investments—Easy Buy, Hard To Sell
For the most part alternative investments are either thinly traded—meaning that there are a very small number of buyers and sellers at any one time—or they are not traded after the initial investment. Some alternative investment funds allow you to redeem the investment if they have the cash on hand, but only at a discount to the original purchase price, which is often 15-20% less than you originally paid. When a fund does not have its own redemptions and when an investment is thinly traded or not traded at all, individual owners may actually have to find someone else to buy the investment from them. That is, they may not be able to rely on a stockbroker or other “market maker” to sell their shares. This is often called “the greater fool” method of selling an investment because you must locate someone more foolish than you to whom you can sell the investment. If you are selling your investment to another person in a secondary sale, you may encounter a very real problem of disclosure and liability. Generally, once you buy an alternative investment, you own it for the duration of the investment period.
Despite these real challenges, alternative investments are an important part of wealthy clients’ asset allocations. They should be used judiciously, with ample caution and never with money that may be needed within short periods of time. For most people, keeping alternative investments to no more than 5% of their total portfolio is within their risk tolerance. Just remember: anything that looks too good to be true is probably false.
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