Hedge Funds, Private Equity, Commodities, Real Estate: Asset Allocation part 2

“Alternative Investments” is a catch-all phrase used to describe investments that don’t fall neatly into the traditional cash, stock or bond categories. You may have some in your portfolio already. Or perhaps your financial sales rep called you with a suggestion to invest in a new hedge fund-like mutual fund. In this post I will provide you with a brief overview of some of the most common alternative investments. I also want to give you permission to pass on any investments that you don’t understand.

It’s not you, it’s them.

Not all that glitters is gold: Commodities

Commodities were originally designed to help farmers reduce their risk by using contracts to buy and sell their crops/livestock before harvest and facilitate trade. For example, a farmer might want to sell half of her cotton crop early because prices are relatively high and she wants to lock in some profit. Once she harvests the cotton she will deliver half of her crop to whoever she sold the contract to and sell the other half of her crop at current prices. Commodities tend to be extremely volatile. Weather events can move commodities markets. I can’t predict the weather, and I suspect you can’t either. Be careful.

Structured Notes (hint: brokers love them)

Structured Notes are a way for brokers to charge you high fees to “express a view on a particular market.” They are complicated. Each one is unique, it would be impossible for me to comment on them as an asset class. Watch out for sales loads (one-time sales fees or placement fees) and high ongoing fees if you are considering buying a structured note. Don’t forget to ask simple questions: is there another way I could access this market? How else could I invest in ____ in a more cost-effective manner? If your financial adviser can’t answer those questions then you are being pitched a product. Get up and quickly leave with your money.

Real Estate: Your House is Not an Investment

I hate to include Real Estate in this group, but I’m going to because many of the investments people are pitched are illiquid private real estate offerings with high fees. (Illiquid means that you may not be able to sell your holding when you want to and when you do you may or may not be able to get a fair price.) Many of these private real estate offerings have hard to understand fee structures, large minimum investments and little liquidity.

If you are interested in including Real Estate in your portfolio you can access publicly traded REITs (Real Estate Investment Trusts) via index funds and ETFs. These publicly traded REITs are much closer to stocks than a private real estate investment in that investors can buy or sell them on an exchange. A REIT is a company that owns or manages commercial real estate or is involved in commercial real estate lending. REITs typically pay a high dividend yield. They can also be quite volatile in price because investors can buy and sell shares in the REIT whenever the stock market is open (just like a stock).

Hedge Funds are for...hedging?

Hedge Funds - what is a hedge fund? Great question, there is no actual answer to that. Generally speaking a hedge fund tries to limit your volatility (how much your investment goes up or down) by using options (the right to buy or sell a security at a specific price), or other trading “strategies.” Traditional hedge funds also have limited liquidity and high investment minimums. Have you ever read “The Emperor’s New Clothes?” If so, then you can understand my opinion on hedge funds.

Are there some hedge funds that do really well for their investors? Probably. Relatively few  funds report their results to any index. Plus the funds that do report and fail, drop out of the index when they close up shop skewing the index results. Which happens. Frequently. The secrecy is part of the allure. You’re either in the club or you aren’t. With a 2 and 20 fee structure I prefer to be out.

“Two and 20” refers to a popular fee structure in hedge funds. Under this arrangement you pay a 2% annual expense ratio (a fee on your investment) for the privilege of investing in the hedge fund. Then you pay 20% of the profits back to the manager once the fund returns more than a pre-set hurdle rate. So if the hurdle rate is 10% the hedge fund manager takes 20% of your return above 10%. Sounds like a good deal. For the hedge fund manager.
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A few years ago there was a rash of offerings of new hedge fund “like” mutual funds. If you are considering one please pay close attention to fees, after-tax return, and what they are invested in. PROCEED WITH CAUTION.

Private Equity (and your small business)

Private Equity is a highly illiquid investment (you could expect your money to be tied up for 12+ years) with significant initial investments ($250,000 on up). The goal of private equity is to extract some (previously) hidden value in a company for the private equity investors. You can read more here if you are interested.

** A really important note about small business owners - in a way, a small business is a private equity investment. It’s probably illiquid (not easily sold and/or may sell at a discounted price), it could have uneven cash flow from year to year, and it could end up being very valuable or worth nothing. With that in mind, small business owners need to -- have to, really -- create their asset allocation with their business in mind.
It’s a lot to think about, I know.

The main things I want you to take away are these:

Now you should have a basic understanding of some of the various “alternative” investments you might be offered by your financial adviser.
Fees matter. You may be shown beautiful past results or historical returns. The keyword here is: historical. The only thing you can be sure of is that fee will be deducted from your investment.
Be very wary of investing in anything you cannot explain to someone else.

As always, please feel free to comment below or email me your questions directly.

Did you miss the post these posts? You will definitely want to read them.

What Is An Asset And How Can I Get One?

Why Fees Matter