Alternative Investments

portfolio chefThe group of investments described as alternative comprises a number of different products, including but not limited to hedge funds, private equity, nontraded real estate investment trusts (REITs), and certain partnerships or limited liability corporations (LLCs). They differ from stocks, bonds, and other traditional investments in several ways, ranging from how they’re structured and sold to the role they may play in a diversified portfolio.

MOVING INTO THE MAINSTREAM

What’s considered an alternative investment at one time — usually when it’s available only to very high net worth investors — may become a more traditional investment later on. For example, the increasing use of certain derivatives, such as equity options and commodities products, has helped move them into the mainstream.

alternative investments

MEETING THE TEST

One way that most alternative investments differ from more traditional investments is that they are offered privately rather than being publicly traded. Some of them are registered with the Securities and Exchange Commission (SEC) though most are not. In either case, the SEC imposes restrictions on who is eligible to invest — which is not the case with publicly traded securities or other investment products.

Specifically, SEC rules require that to be considered an accredited investor — and therefore eligible to invest in hedge funds or private equity partnerships — an individual must have a net worth of at least $1 million not counting the value of his or her primary residence or an annual income of at least $200,000 if single, or $300,000 if married, in the two most recent years. There must also be a reasonable expectation for that level of income to continue. Institutional investors are also accredited, as are charitable organizations or trusts with assets of at least $5 million.

Some alternatives that are registered with the SEC may be suitable for a broader range of investors. The net worth and investment amount required to participate are generally lower than for hedge funds or private equity funds. The appeal is that the return on these products, which strive to provide regular income, is noncorrelated with the return on traded securities.

Typically, you invest through a direct participation program (DPP) that’s run by a general partner and invests money raised from a pool of limited partners. Investing in a DPP is a long-term commitment, often ten years or more, and the secondary market is thin. But there may be tax advantages with these investments that may help to offset some of their risks.

UPPING THE ANTE

poker chips Should individuals be required to have a net worth of $5 million to be accredited investors? The argument in favor is that while increasing numbers of people have accumulated a net worth of $1 million, they may not necessarily have enough investment experience to put money into alternative products.

FROZEN FAIRLY SOLID

Alternative investments are often highly illiquid. That means there’s no secondary market where they can be traded easily, and the buy-back programs that some of these investments offer are often limited and may impose stiff fees. From the sponsor’s perspective, illiquidity is an advantage since it means that the partnership or corporation does not ordinarily have to buy back shares that investors want to sell. For investors, this illiquidity may help provide a buffer against the volatility that often affects conventional markets.

One reason that alternative investments require a longer-term commitment is that their managers may employ strategies that take an extended period to produce results. The term of the investment, also described as a lock-up period, isn’t the same for all the products but does apply to most of them. In hedge funds, for example, it’s often one year but could be less. In private equity it may be unlimited.

As a potential investor, you should always take into account the specific provisions that apply to a particular investment that you may be considering.

FUNDS OF FUNDS

Funds of hedge funds (FOHF) are investment funds that build a diversified portfolio of existing hedge funds. The FOHF manager is responsible for researching, choosing, and monitoring the funds in the fund, tasks that may exceed the expertise of an individual investor or investment adviser. The appeal of a fund of funds is that it offers exposure to a range of hedging strategies that, overall, may have the effect of reducing portfolio risk.

Fees are one potential drawback to a fund of funds. In addition to the management fees you pay to own the fund of funds, there are management fees associated with each of the funds within the FOHF. And, in addition to the performance fees the underlying funds charge, your fund of funds manager may also be eligible for a performance bonus, which you, as a shareholder, will pay as well.

Investors who buy a fund of funds may know which hedge funds their FOHF owns, or they may not. Levels of transparency vary. In fact, in some cases, certain investors may have information about the portfolio while others don’t.

COUNTING THE COST

The price tag on alternative investing includes not only the required minimum commitment but also substantial fees. The investment minimums vary widely, from as little as $2,500 for some private nontraded REITs to $1 million or more for some hedge funds.

The fees, which can be substantial, are computed differently for various investments. In the case of hedge funds and private equity partnerships, the issue is the percentage of profits.

INVESTMENT FEES

Hedge funds

1% to 2% annual asset-based fees plus 18% to 20% of fund profits

Private equity funds

1.5% to 2% annual asset-based fees plus 18% to 20% of fund profits

Private, nontraded REITs and other direct investments

Up to 16% up front, amortized over the investment term


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