Alternative Investments: Buyers Beware
There is a spirited debate within the investment community on the role that “alternative investments” should play in one’s portfolio. In the simplest of terms, an alternative investment is an investment in an asset class other than stocks, bonds and cash. One of the rationales used to promote these investments is that by introducing alternative asset classes that are not highly correlated with stocks, bonds and cash, one can lower the volatility of a portfolio. There is often a presumption that performance is not harmed, which is not necessarily true.
There are many types of investments that could fall under the category of an alternative investment. Real estate, precious metals, commodities, private equity, distressed securities, and hedge funds are such examples. In fact, Sigma has approved the use of two exchange-traded funds that provide exposure to real estate investment trusts (REITs) and gold. Moreover, many of our clients have investments in real estate, precious metals, private equity, etc., which is outside of our active management. So clearly, alternative investments oftentimes play an important role in one’s financial plan.
However, we are also seeing the proliferation of alternative investments which are being marketed to a much broader audience with the pitch that investors “need” these products to lower the volatility of their overall account. If this must-have investment is proven to be successful in reducing the volatility of a portfolio, but in the process also reduces the underlying return of the account, has value really been created? Was volatility a problem that needed to be fixed in the first place? Could not the same impact been created by changing the amount invested in stocks, bonds, and cash, without introducing a new asset class?
In addition, investment products with outstanding short-term returns often go in and out of style. So, one must question whether the particular alternative investment that has a great short-term performance streak, has the staying power to perform as well, over the long run.
We are also mindful that there are often high costs associated with these alternative investments. These costs may add fees and include other risks and limitations worth noting, such as the following:
- Loss of principal due to leverage, short-selling and/or other speculative trading practices
- The tendencies to have lock-up provisions, and secondary markets which may not exist
- These investments may also lack portability, so transferring the asset may be difficult
- Lack of daily market valuations
- Complex tax structures resulting in delays in tax reporting and added filing costs
- Less regulation than traditional investments
- Lack of clear benchmarks holding the manager accountable for subpar performance.
In summary, we are not opposed to the use of alternative investments. We are opposed to the sale of these products when there is not a clear understanding by the investor of what they are buying, how the investment fits into one’s financial plan, and what the risks and limitations are. Buyers beware.
All comments and suggestions are welcome.
Christopher J. Kress, CFA®