Many investors in alternative investments are in for unpleasant surprises. Alternative investments are very popular these days, as traditional stock and bond investments are not doing well. Alternative Investments include a wide variety of investments that fall outside the traditional stock and bond categories. Examples include structured products (such as principal protected notes and reverse convertibles); hedge funds; private equity; nontraded REITs; niche, leveraged, inverse leveraged, and synthetic exchange traded funds; and many others.
The main selling point for alternative investments is that historically they are not well correlated with traditional stock and bond investments. In appropriate amounts, therefore, such investments may provide diversification and risk reduction. However, they are often misused for speculation rather than diversification and often represent high concentrations in an individual investor’s portfolio. Since alternative investments are typically illiquid and volatile, investors can get hurt badly.
Most people do not know much about alternative investments. That includes the people who recommend and sell them. 52% of financial advisors admit they do not “feel as knowledgeable about alternatives as they would like to be.” (Translation: Most of them know just enough to be dangerous.) Almost 90%, however, feel comfortable talking about them with clients and are recommending alternative investments, such as structured products, managed futures and commodities funds, hedge funds, private equity, and so on. See “Alternative investments aren’t for everyone,” MarketWatch. This obviously presents a very dangerous situation for investors.
The article says that this danger can be effectively dealt with and avoided by meaningful investor education. According to the article and some investment advisors, ordinary investors can learn enough to evaluate alternative investments and reach appropriate conclusions. In order to do that, they say, one need not have a doctorate in alternative investments, but need only develop an understanding of basic concepts such as the cost and fees associated with the investments, the lack of liquidity, and the nature and likelihood of the various risks. It sounds reasonable on the surface but it is wrong. Here’s why.
Evaluating alternative investments is virtually impossible for outsiders. To understand whether an alternative investment is suitable, an investor needs to be able to evaluate the range of possible outcomes and their likelihood of occurrence. Manager track records and performance statistics are often unavailable or misleading.
Prospectuses and marketing materials may list boiler-plate risks but rarely disclose the likelihood specific risks the investment is facing. So the answers to basic questions such as “What’s the worst possible outcome?” and “How likely is that?” are simply not available to investors. The investor can ask his financial advisor, but most of them do not know the answer either.
In order to answer the basic question: “How does the investment work?” the investor must be able to conduct due diligence. Most investors lack the background, time and ability to interview and investigate managers and promoters, evaluate strategies, methods and fees, make appropriate comparisons to other investments, and reach appropriate conclusions. The fees are embedded and not transparent.
REITs and private equities often involve transactions by and among people with interests that conflict with the investors’, such as asset acquisitions that were not done at arms-length and were made at too-high prices based on inflated appraisals. Hedge funds give managers virtually unlimited discretion and provide little or no verifiable information to investors about what the fund is doing. Again, the investor must rely on his financial advisor and/or the selling firm, but most of them have not performed (and could not perform) the necessary due diligence either.
But even that is not enough. Many alternative investments use derivatives whose complexity is impossible for ordinary investors to evaluate. They produced nonlinear (kinked) outcomes and non-normal (skewed) distributions. To determine whether they are fairly priced, one would have to be able to do the Black-Sholes mathematical computations that earned a Nobel prize.
What is really going on in sales of alternative investments is the blind (with a powerful financial incentive to make the sale) leading the blind. It is not enough to say that alternative investments not for everyone. Every investor should think twice and more before buying one.
Page Perry is an Atlanta-based law firm with over 150 years collective experience representing investors in securities-related litigation and arbitration. While past results are not indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 45 occasions. Page Perry’s attorneys have extensive experience in representing investors in cases involving hedge funds and other alternative investments. For further information, please contact us.