I work with many physicians and other high-net-worth individuals who meet the "Accredited Investor" criteria to invest in alternative asset investments. The wealth management industry makes a lot of money off these investment products, and advisors love selling these products to anyone they can. While traditionally only aimed at institutional or accredited investors, alternative investments have also begun making their way down to the retail level through mutual fund products that invest in these alternative assets.
What are Alternative Asset Investments
An alternative asset is considered any investment asset that falls outside of the traditional three investment categories of stocks, bonds, or cash. Common alternative investments include:
1. Private Equity/Venture Capital
Private equity and venture capital include partnerships that invest capital into private companies (i.e., not listed on a publicly-traded exchange). The investments can focus on startup and early-stage ventures to more mature companies seeking to expand or restructure.
2. Private Debt
Private debt refers to debt investments that are not financed by banks and are not issued or traded in an open market. Partnerships that invest in private debt provide debt capital to private companies that cannot obtain sufficient traditional bank financing and lack the ability to tap public debt markets.
3. Hedge Funds
Hedge funds are partnerships that actively manage investment pools whose managers attempt to capitalize on any number of "market opportunities." Hedge funds are unique in that they can use leverage, derivatives, and take short stock positions. Hedge funds today present a diverse group of partnerships that employ any number of investment strategies, including Long-Short, Market Neutral, Merger Arbitrage, Convertible Arbitrage, Event-Driven, Credit, Fixed-Income Arbitrage, Global Macro, Short-Only, and Quantitative.
4. Real Estate
Real Estate partnerships can invest in any number of real estate investments, including raw land, manufactured housing, timberland, mobile home parks, farmland, apartment complexes, office buildings, retail space, and more.
Commodities represent investments in real assets such as agricultural products, oil, natural gas, and precious and industrial metals.
Collectibles include a wide range of physical objects that have the potential to appreciate in value. Collectibles can be anything anyone collects, but a few categories include stamps, coins, toys, fine art, and wine.
7. Structured Products
Structured products represent any number of pre-packaged structured finance investment strategies. Structured products come in numerous varieties of underlying assets and linked derivatives. Structured products can be complex and sometimes risky, but investment banks design them to offer investors a particular product mix to meet a particular payoff profile need. Two structured products that became infamous during the 2007-2008 financial crisis were collateralized debt obligations (CDO) and mortgage-backed securities (MBS). Investors piled into these investments when the housing market boomed before the crisis and then suffered severe losses when housing prices declined.
Why Do Individuals Consider Alternative Asset Investments
Most individual investors do not stumble upon these "opportunities" on their own. They are often presented to investors by advisors who personally, or whose firm, stands to benefit from their sale. Again, the wealth management industry makes a lot of money off these financial products, so they have plenty of money to employ skilled salespeople with educational credentials and offer lucrative incentives.
The advisors' pitch usually includes some mix of the following reasons:
- Portfolio Diversification (true, but at a high cost, there are better ways)
- Exclusive Opportunity Rarely Available
- Potential for High Returns (sometimes even claiming high risk-adjusted returns; based on an improper definition of risk)
Individual Investors Should Avoid Alternative Asset Investments
Individual investors should avoid alternative investments based on the following three reasons:
The reason most alternative investment assets can only be sold to institutional investors or accredited, high-net-worth individuals is because of their complex nature, lack of regulation, and degree of risk. I would argue that few accredited individual investors even have the resources or expertise (that institutional investors may have) to adequately understand and value these investments well enough to make a proper decision. Additionally, most alternative investments require high minimum investment amounts, only raising the stakes.
Alternative investments usually do not have to register with the Securities and Exchange Commission like traditional mutual funds or ETFs. This lack of regulation and oversight makes alternative investments more prone to the possibility of fraud or scam. Further, private companies are under no obligation to reveal earnings, financial information, or report to shareholders, which means that information on these types of assets can be hard to find.
Another important factor to keep in mind is the risk asymmetry involved when it comes to investing in an alternative investment partnership. As we will discuss next, the manager typically gets paid annually through a management fee and receives a performance fee equal to some amount of the gains. Because of this fee structure, the manager does not really have any downside risk, which can lead to excessive risk-taking. Being more conservative only lowers the manager's potential compensation and dampens their reputation and ability to attract more capital.
While it does vary, most partnerships are compensated on what's known as a '2/20' fee structure. A 2/20 fee structure is composed as follows:
- 2% Management Fee - an annual fee charged by the manager to cover the operating costs of the investment vehicle.
- 20% Performance Fee - an incentive fee viewed as a reward for positive returns.
Given this fee hurdle, it is hard to see how an investor can expect to receive a return commensurate with the true risk being taken.
Alternative investments often have lock-up provisions that restrict an investor's ability to withdraw capital from a fund for some stated period of time. Even after this lock-up provision time, receiving cash from a sale may take 30 to 90 days. Further, the decision on when to liquidate is made difficult by the lack of regular pricing data. Unlike a mutual fund with end-of-day pricing or an ETF with intra-day pricing, alternative investment funds may only provide pricing data based on monthly or quarterly valuations. Lack of liquidity can be problematic for individual investors who are subject to possible unforeseen emergency needs for cash.
A Traditional Index-Based Approach to Investing is Best for Retirees
The issues alternative asset investments bring to individual investors are only exacerbated when approaching retirement. Retirement is a time to lessen risk, shed excessive cost, and maximize flexibility. An investment portfolio built using low-cost index funds to build a maximally diversified portfolio of traditional investments is the best way to accomplish this goal. (see our Insight entitled "Building an Investment Portfolio for Retirement" for more).
If you would like help constructing a portfolio for retirement, we stand by ready to help. To learn more, you can schedule a date and time that is convenient for you here at this link: https://calendly.com/thriveretire/thriveretire-call or contact us here at any time.
ABOUT THRIVE RETIREMENT SPECIALISTS
Thrive Retirement Specialists is a retirement planning specialist dedicated to delivering a more thoughtful and strategic approach to retirement planning for those nearing or in retirement. We are a fee-only Registered Investment Advisor (RIA) offering a single, flat-fee service entitled ThriveRetire™ that goes far beyond what has traditionally been known as retirement planning. ThriveRetire™ is an engaging ongoing 8-step retirement planning process and investment management service that seeks to identify all risks, assets, tools, and tactics to develop an optimal retirement plan designed to support your ideal retirement lifestyle and goals to the fullest extent possible. With every interaction, we seek to inform and serve, so our clients can safely trust their ThriveRetire™ plan and process, leaving each client with the confidence and peace of mind to live a vibrant and full life through retirement.
ABOUT ANTHONY WATSON, CFA, CFP®
Prior to founding Thrive Retirement Specialists, Tony spent eight years serving as the Chief Investment Officer of a firm where he provided advice and investment management services to over 600 individuals representing at the time over $1.5 billion of investments. Before this, Tony served as Vice President at J.P. Morgan Private Bank, where he advised high- and ultra-high net worth individuals on all matters of wealth, including investments, portfolio construction, portfolio management, and retirement planning.
Tony lives in Dearborn, Michigan, with his wife Dawn and daughters Emma and Anna.
- BBA in Finance, Walsh College
- MBA, University of Michigan, Ross School of Business
- Chartered Financial Analyst (CFA)
- Certified Financial Planner (CFP®)