Alternative investments can offer the potential for enhanced returns, but they typically involve higher risk, limited liquidity, and more complex fee structures. Careful due diligence is essential before incorporating them into your portfolio.
In this article, we’ll cover
Put simply, they’re alternatives to stocks and bonds. Alternative investments can include things like:
Pros:
Cons:
Alternative investments can sometimes deliver higher returns than traditional portfolios, but that potential reward usually comes from taking on additional risk and accepting limited access to the invested funds.
With some alternative investments, you may lose access to your money for years. Should an unplanned expense arise, you’ll need easy access to other funds (liquidity) from another source.
For example, in a private equity or private credit deal, there could be a 7-10 year “lock-up” period. Even if the alternative investment is packaged in a mutual fund wrapper, the fund may not have daily liquidity. Many alternative mutual funds use a structure called an interval fund.
An interval fund is a type of mutual fund in which investors can sell their shares only at specified intervals, such as once per quarter or once per year. There can also be restrictions around how many shares can be sold at each interval. In other words, it could potentially take several years for an investor to fully liquidate their holdings.
Think back to 2008. Investors with publicly-traded stocks in banks and mortgage lenders could have sold their stocks and cut their losses early. But investors with money in illiquid interval funds may have waited months, even until the end of the year to fully liquidate their holdings.
A common selling point of alternatives such as venture capital and private equity is the ability to get in on the ground floor of the next great company. Google, Netflix, Amazon and many others were funded with venture capital in their early growth phase.
Everyone wants to be an investor in the next Google, but remember that 90% of startups end up failing. Statistically, it’s much more likely you’re investing in the next Pets.com than the next Google.
As the chart below shows, private equity and venture capital returns vary widely, especially compared to US Large Cap equity. On the left side of the chart, you can see US Large Cap manager returns are tightly bunched and clearly in positive territory.
The right half of the chart shows returns for venture capital, private equity and hedge funds (all considered a form of alternative investment). The returns are all over the place. The 75th percentile venture capital manager returned 15% annualized over 10 years, while the 25th percentile manager lost 4.1% annualized over 10 years. That means 25% of venture capital managers averaged an annual loss of more than 4.1% per year over the last 10 years.
Alternative investments generally have higher fees than a typical mutual fund or Exchange Traded Fund (ETF) because they tend to require specialized and sophisticated strategies. A hedge fund, for example, may charge a management fee of 2% of the assets under management and a performance fee of 20% of the profits of the fund.
It’s important to fully understand all fees associated with an alternative investment and how they will impact the investment's performance before committing to buy. Fee structures can be very complex and include things like a hurdle rate, where a fund must meet a minimum return (the hurdle) before collecting fees. There may also be a redemption fee, meaning the investor must pay a fee to withdraw their money.
There can also be multiple layers of fees. A private equity fund might buy into another private equity fund, which creates two layers of fees on the same investment for the end investor.
The fair market value of a publicly traded stock is straightforward. With every trade, a buyer and a seller agree on the fair price of the stock at the time of the transaction.
Determining the fair market value for a privately held company is more complex, especially because private companies are not subject to the same rigorous public disclosures as public companies. Most private equity companies use a complicated “mark-to-model” process to determine value. But because there is no liquid market to validate their valuations, it’s hard to know if the price is fair.
Legendary investor Warren Buffett referred to the mark-to-model process as “mark-to-myth” because he believes the pricing of illiquid assets (such as private equity) is typically based on overly optimistic assumptions. In Buffett’s view, mark-to-model valuations are unreliable and misleading because they rely on so much subjectivity.
Buffett says, “We have seen a number of proposals from private equity funds where the returns are not calculated in a way that I would term as honest.”
Hedge funds and direct private equity investments are frequently structured as partnerships, which typically issue a Form K-1. A Form K-1 will make your tax preparation process much more complicated, especially because these forms won’t necessarily be issued prior to April 15th. This will necessitate filing an amended return or filing for an extension every year.
Be sure to consult an independent tax professional to make sure you fully understand the tax-related implications before investing in an alternative investment.
If the stock market takes a dive, certain alternative assets may hold their value. Put another way, some alternative investments can have a low correlation to traditional stocks and bonds.
Investors looking for a hedge on an existing equity portfolio might consider investing in commodities or other real assets. A private equity fund, however, would not be a good choice.
As the chart below shows, private equity returns have a strong correlation with global (public) equity returns. But investments in real assets, such as timber, are not strongly correlated to stocks.
Investing in alternative assets can be financially rewarding, but they’re not a good fit for everyone. Due to the complexity described above, potential investors must conduct detailed and methodical research before investing. A thorough due diligence process is the only way an investor can determine whether an alternative investment is truly a good fit for their portfolio.
If you’re considering alternative assets and unsure where to start, consult a financial planner who is familiar with alternative investments. We’re happy to answer any questions you may have. You can contact us online or by phone: (415) 541-7774.
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