As their name implies, alternative investments typically involve investments other than one of the three conventional asset classes: common stocks, bonds and cash. These investments are alternative in the sense that they purport not to be closely correlated with traditional financial markets. In theory, when common stocks or bonds zig, alternative investments zag. This feature, if present, tends to reduce volatility.
Alternative investments are highly complex investments that involve significant fees and risk of loss. They include venture capital investments, private equity, hedge funds, exchange-traded funds, limited partnerships, structured products, and junk bonds.
Most alternative investments were first used by institutional investors. They were often tailored to meet a specific investor’s needs. They became popular with individual investors in recent years when traditional stocks and bonds produced reduced returns and high volatility. Alternative investments typically use techniques such as shorting, hedging or taking long-short positions. They also often use complicated instruments such as options, derivatives and hybrid securities in an effort to achieve their goals. Many of these techniques are highly complex and/or require knowledge of advanced mathematics to even begin to understand the product. Moreover, the actual implementation of the strategy is opaque and virtually impossible to follow.
The liquidity of alternative investments tends to be poor or absent. Private equity, natural resource limited partnerships, and real estate often require lockup periods of 10 years or more. Many hedge funds have lockups of several years. Redemptions, if available, are often restricted to specific periods, and may require up to 6 months’ notice. In addition, these investments generally are not traded on any market. Thus, there is no way to determine the value of these investments, and they are difficult, if not impossible, to sell.
Finally, most alternative investments involve extremely high fees and related costs.
Why then are so many investors attracted to alternative investments? In this regard, it is important to understand that alternative investments are said to be “sold not bought,” meaning that sales are often the result of aggressive marketing rather than investor demand. In the volatile bear markets following the tech wreck, the credit crisis, and the economic and market turmoil of 2008-2011, many investors reported that they were uncomfortable investing in the stock market. In fact, over the last decade, the returns of many equity investors have not kept up with inflation. Since investors wanted better returns with a hedge against the downside, promoters have sold alternative investments by promising protection against stock market declines plus returns that range from reasonable to outright eye-popping.
Wall Street is very adept at creating new products designed to have broad appeal. Unfortunately, both the downside protection and upside potential of alternative investments tend to be exaggerated. When an alternative investment is successfully marketed, others flood the market with competing products and investors pile in. This has happened with both exotic exchange-traded funds and hedge funds, for example. This can lead to a bubble and its inevitable bursting.
Despite claims to the contrary, alternative investments are sometimes highly correlated with traditional financial markets. For example, correlation between financial markets and hedge funds reportedly spiked to almost 80% in August 2011. As a result of this and other factors, such as the use of leverage and concentrated positions, alternative investments can be highly volatile.
Alternative investments suffer from extraordinarily high fees and expenses, and, as a result, they must earn substantially higher returns than a traditional equity or bond mutual fund just to equal the returns of such investments after fees, expenses, and taxes. To have a chance of doing that, they must expose investors to substantially higher risk, usually in the form of high leverage and concentrated positions.
The complexity of alternative investments makes them difficult for advisers and their clients to understand. They are fraught with risk, much of it not well-understood by advisers and, therefore, not explained well to investors. Advisers and their clients should carefully evaluate these products before recommending or investing in them. Unless they are looking for an investment that is like picking up nickels in front of a steamroller, most alternative investments should be avoided.
If you have investment losses or problems involving alternative investments, call the lawyers at Page Perry for experienced representation at (770) 673-0047 or (877) 673-0047 (toll free).