Be very careful in evaluating and making alternative investments. By following some specific
rules you can increase your chances of a profitable outcome.
By Robert Hockett, CFP®
For 8-10 years now hedge funds and alternative investments have garnered worldwide praise on one hand and worldwide scorn on the other. To determine if alternative investments belong in your portfolio, first you need to know what they are, which is easiest to understand by defining what they are not:
Alternative investments are those financial investments that are separate from and which act differently from New York Stock Exchange/American Stock Exchange/NASDAQ Traded common or preferred stocks or municipal/corporate/or US Treasury bonds. They are also different from Real Estate Investment Trusts (REITs) which are traded on national exchanges like mutual funds. Whether individual stock shares or bonds as mentioned above, or REITs, or in the form of pooled investments like equity or bond mutual funds, all of these are often called “conventional” investments. This is where most of your attention needs to be in your investment portfolio. In my opinion, conventional investments should make up between 90-100 percent of your total investment portfolio.
For many individual investors, alternative investments are totally inappropriate. I do not usually recommend them to any client with investment assets under $1,000,000. For any client under $10,000,000 in investment assets I recommend no more than 5 percent in total alternative investments. From a rational investment approach, alternative investments are designed to do one thing in an investment portfolio – add additional diversification. They do this by providing exposure to an investment area or “class” that is non-correlated to the other conventional investments in the portfolio. So, while most individual investors should avoid alternative investments, everyone should know something about them. We should start with a discussion of correlation and diversification.
Investment Correlation and Diversification
Let’s discuss correlation in an investment portfolio in a simple way:
Positive Correlation is the movement in the same direction of two or more individual investments or classes of investments. For example, pick the two biggest oil company stocks. If one is up in share price, the other stock is probably up as well. They are similar enough to move closely in the same direction -- both up and down in the market with the same market conditions. As they are more positively correlated, they may even move in the same percentage as the other, up or down.
Inverse Correlation is the movement in the opposite direction between two or more individual investments or two or more classes of investments. With the above example of two oil company stocks, let’s introduce a probable inverse correlation – an airline stock. As the price of oil increases, so do the profits of oil company stocks. The increase in the cost of oil increases the cost of airplane fuel, raising the costs for airlines and therefore putting downward pressure on their profits. This drives airline stock prices down. So, when oil company stocks go up, airline stocks go down, an inverse relation.
Non-Correlation is the absence of a pattern of correlation in either a positive or negative direction. A long-short hedge fund may have no correlation to either oil stocks or airline stocks unless the fund exclusively focuses on either type of stock, excluding all others. There is no coherent pattern of correlation.
In building investment portfolios, a wealth manager seeks to have both positively and negatively correlated investments. This way when one part of the portfolio is down another part is up. This relationship lowers the total volatility or variability of the portfolio. Non-correlated investments also provide a positive benefit in the construction of an investment portfolio because, when added to all of the other investments, it lowers the volatility of the aggregate portfolio. Since volatility is synonymous with risk, additional diversification lowers volatility, and therefore lowers risk. When alternative investments are used correctly, they can lower the overall risk profile of the investment portfolio as a whole -- even when they themselves may have a higher than average risk.
While this makes a case for alternative investments from the side of diversification, it does not address some of the inherent problems and challenges in selecting among alternative investments as its own asset class.
Different Types of Alternative Investments
There are several types of alternative investments, the most common ones are hedge funds, venture capital funds, barely public companies, family and friends financing, and real estate or lending partnerships or LLCs.
Hedge Funds
These are funds that pool investors’ money and typically have one person or a small group of persons who provide investment guidance in some very specialized areas of the investing universe.
Strategy Specific Hedge Funds: Generally stay focused on one specific area such as currency futures (dollars vs. Euros vs. yen), collateralized mortgage debt (billions were lost recently in this strategy), and long-short funds (going long on some stocks while short on others to play market turbulence, while interest in the specifics of the underlying stocks is agnostic).
Opportunistic Hedge Funds: Generally focus only on making money. They may move around in a wide range of areas depending on where they feel they can make money. The goal is only to make money; the specific strategy is secondary. These are the hardest to evaluate since there is a high probability that investment performance is situational and will be therefore impossible to duplicate.
Venture Capital Funds
Venture Capital Investments: Are generally well known as early-stage investments in small or medium-sized companies. Since the highest percentage ownership comes the earlier that the investment is made, these tend to be risky investments. The small business is often helped by experienced managers who are hired by the venture capital fund. The business is grown to some sort of profitability, and then sold to a strategic industry buyer or sold through an initial public stock offering. The more successful funds tend to focus on a specific type of industry such as technology, biomedical, or now, alternative energy. The objective is to make say 10 investments that are projected to make 20-40 percent annually. The reality is that 6-7 will fail, 2-3 may break even, and one might do really well. This way the one big success makes up for the failures, and the fund makes money overall. The best key for success is to only invest in tried and true venture capital teams that have a long and proven track record. Brand new venture capital firms may be 3-5 years old and still not have proven themselves since the building of companies and the development of exit strategies is often a multi-year process.
Barely Public Companies
Barely Public Companies Looking for Capital: These are companies that are trying to move along the product cycle, enter a new marketing channel, or develop or launch a new product, all of which will reportedly make the company move to the next stage. These companies are usually in a precarious situation. One that I reviewed recently was losing so much money that if the round of additional money was not found within a few weeks, the company would go bankrupt. These pitches are usually Power Point presentations given by someone who has funded the company already and has a lot to lose if they do not get additional funding immediately. This is one of the most risky types of alternative investments. The companies generally have high overhead and are not as lean as they could be. This is the reason they're out of money. They usually represent a great idea that has not been well executed with the available resources, and the company now only has enough resources to make it through months, if not weeks. The investment is designed to help carry them through the rough spot, but this alone does not insure that they will execute strategy well or that they will not call you four months after your initial investment and tell you how much you just lost. The key is to make sure that any money you decide to invest is NOT paying out any earlier investors, that the company has a sound business plan, and, most importantly, that the numbers make sense. Be very cautious of the financial assumptions, which are at best positive spin and at worst completely unrealistic fabrications. I recently saw one that had a future sales projection that went from a $3,000,000 annual current loss to a $40,000,000 annual profit with a 5,000 percent increase in top line revenue -- all in four short years. They had already been in business for five. Unlikely at best, but deceptively foolish for the unsophisticated investor.
Family and Friends Funding
Family and Friends Adventure Capital: This is still how most small businesses raise their investment money. The risks are obvious: lack of business expertise, lack of financial controls, lack of liquidity, and lack of industry knowledge. There are millions of small businesses that have been funded this way and succeeded, just as there are additional millions who have been funded this way and failed. Our advice is to ask four questions.
- Can you afford to lose the money?
- If the business is an “s” corporation, did you select a section 1244 election in the incorporation documents? (The last time that I checked this would allow you to take a loss against ordinary income instead of against capital gains plus $3,000 per year).
- Is everything in writing?
- Can you afford to lose the money(repeat this a couple more times just so you are clear on this)?
In addition, are they working with a Small Business Administration (SBA) lender who will generally require them to write a business plan and pledge personal guarantees and their home equity as collateral? There are few more powerful incentives to full mental concentration than to lose your home if you are wrong. Be very careful of the friend or relative who is eager for you to risk a significant amount of money who will not put his own money on the line unless he has a history of successful “deals”. I have seen would-be small business owners who refused to pledge their own homes to the SBA but were quite happy to ask our clients to use their significant investments, or even if they were already fully-allocated, to borrow to fund the proposed business.
Real Estate or Lending Partnerships or LLCs
Real estate partnerships: Partnerships have raised money through small offerings for a very long time. These partnerships (or in the last 15 years Limited Liability Companies- LLCs) usually have a managing member, which is another partnership that has significant experience in real estate development, management, redevelopment, or the entitlement process. Money is pooled and used to purchase, develop, or redevelop real estate in the areas of commercial, residential, retail, or industrial properties. These partnerships as also used to purchase raw land and complete often complex zoning requirements. These investments are often for fixed periods of time, typically 5-7 years. The specialized benefit is added to the property by the subject matter expert (the managing member), and then when realized, by the larger market, the property is liquidated and the original investment is returned to the investors with appreciation. In the case of developed properties, there is often a quarterly dividend of a percentage of the rental income paid to the investors.
A variation on this theme is the use of partnerships to fund lending pools to other real estate projects. While partnerships have done this for many years, recently a rash of fraudulent lending pool partnerships have sprung up. These are also called hard money loan pools. Investors should be very wary of any investment that promises to pay out 2-5 percent PER MONTH in these partnerships. Recently a client who did not follow our advice lost $100,000 in one of these fraudulent partnerships. Others lost a total of $31 million in this same Midwestern partnership. The key is to work with someone whom you trust who also has a track record for successful partnerships. There may well be more opportunity in this area in the future, as credit is tight, and banks are not as willing to lend.
Conclusion
Alternative investments can bring additional diversification to an individual’s investment portfolio. Selecting among different individual investments requires evaluating the specific merits of each and filtering down to an investment that makes sense for you. It's the same with alternative investments. This asset class is among the most complicated asset classes in modern investing. Proper selection requires research, due diligence, and significant amounts of caution. Always keep in mind that more than a five percent allocation of your total portfolio to alternative investments may exceed your total risk tolerance. Alternative investments are an important part of a wealthy client’s asset allocation. They should be used judiciously and with ample caution, and never with money that may be needed within short periods of time. And finally, anything that looks too good to be true is probably false.
For part 2 of the article click on this link:
“Alternative Investments: Part 2
Five Challenges of Alternative Investments”
Copyright © 2007-2010 Robert S. Hockett, CFP® All rights reserved.
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