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Alternatives
to traditional investments
Investors
sometimes get bored with traditional investments, such as U.S. stocks,
investment-grade bonds, and the mutual funds that are invested in those
asset classes. Especially when such investments fail to generate adequate
returns as they did in 2005. And when that happens, investors often tend
to hunt for what some refer to as "alternative" investments,
investments with exotic names that hold out the promise of higher returns.
Alternative
investments are, in simple terms, nothing more than investments that offer
investors the chance to diversify their portfolio with instruments that
may reduce overall risk of the portfolio and potentially improve returns.
Typical alternative investments include hedge funds, commodities (futures
and options), direct ownership of real estate, REITS (public and private),
limited partnerships, private-equity funds, venture capital or angel
investing, mutual funds (absolute return funds, long-short funds, and
covered writing funds) and managed futures.
Besides the
potential for higher returns and lower portfolio risk, alternative
investments also have these general characteristics: higher fees, higher
investment minimums, minimum net worth and income requirements for
investors, and illiquidity (3 to 5 year commitments are not uncommon). In
addition, investors may find it difficult to find appropriate benchmarks
against which to measure performance and risk, unlike, for example, using
the Dow Jones Industrial Average or the S&P 500 to measure the
performance of stocks.
As with all
investments, alternative or not, it would be useful to remember what the
Romans used to say: "caveat emptor" - or "let the buyer
beware" – when researching such investments.
So, if you are
considering adding alternative investments to your portfolio be sure to
get a sense of your current assets’ combined potential for return and
risk and consider whether it would be realistic to make changes that could
significantly enhance your potential return without an excessive increase
in your potential risk. Often, a major benefit of adding alternative
investments is that it tends to reduce the overall risk of a portfolio
because the value of such investments doesn’t always follow that of
stocks and bonds. In other words, traditional investments and alternative
investments are not "correlated."
Here’s a closer
look at some of the more common alternative investments out there:
Hedge Funds.
Hedge funds are nothing more than investment partnerships and, as such,
are often precursors of mutual funds. Some do nothing more than allow the
investor to share the results of the expertise, experience and talents of
a respected manager. Others may pursue very conservative strategies
focused on principal protection. The key thing to recognize, according to
financial planners, is the focus on absolute returns as opposed to
relative returns and benchmarking. That said, it’s important to note
that hedge funds may resemble mutual funds but are far from identical. For
instance:
 | The costs of owning them are a
lot higher because they not only charge annual management fees (around
1-2 percent), they also commonly charge performance fees of 20 percent
of the funds’ profits. |
| They may use speculative
techniques, such as borrowing money to supplement investors’ money
and investing in illiquid securities that can make them more risky. |
| Neither the funds nor most
hedge fund managers are required to register with the SEC. |
| Because of their higher level
of risk and little or no SEC oversight, hedge funds tend to be made
available only to the wealthy—those who have net worth of at least
$1 million. |
| They may only accept
redemption requests quarterly, as opposed to daily, and may impose
"lockup" periods of a year or more during which no shares
may be redeemed. |
Futures and Options.
Futures contracts commit you to buying or selling something for delivery
in the future at a certain price while options contracts give you the
right—but not the obligation—to do so.
Once primarily used
for agricultural commodities, futures contracts now are also available in
a growing variety of markets from metals and fuels to financial
instruments including foreign currencies, U.S. and foreign government
securities, and U.S. and foreign stock indices.
Prices can be highly
volatile to reflect ever-changing balances between supply of and demand
for the underlying assets.
Precious Metals.
The volatility of the price of gold, for example, the most widely watched
metal worldwide, illustrates why it is, at best, a speculative asset when
not purchased for actual use. Now trading near $600 an ounce, it remains
far below its all-time high of around $1,000 about 25 years ago—but more
than double its most recent lows around $250 at the end of the 1990s.
Anyone who bought
gold 25 years ago as a long-term investment and held it would have lost a
lot of money if he or she sold today—not to mention the missed
opportunities for capital gains in securities. The lesson to be learned is
that alternative investments are available for those who want to diversify
their portfolios, however, they should be fully understood before you
invest in them.
April 2006— This column is
produced by the Financial Planning Association, the membership
organization for the financial planning community, and is provided by
McGuire & Co., LLC, a local member of the FPA.
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