Alternative Investments

Since the financial crisis, we have seen a dramatic increase in the assortment of investments going under the catch-all term “alternatives,” or “alts.” The basic thinking that gave rise to these strategies was the extraordinarily high correlation of asset classes during the recession and the nearly desperate attempt to find investments whose values moved more independently from the traditional market.   When the time-honored safeguard of classic diversification largely failed, the broad variety of alternative holdings such as metals, real estate, managed futures contracts, commodities, and derivatives became very attractive… especially among institutional investors and hedge funds.  And when the big dogs start showing excitement for a strategy, a bunch of little ones jump in to get a bite. 1

So, over the last few years, as clients have brought their portfolios in for our review, we’ve seen an increasing amount of alternative investments which had apparently been sold promising both a low correlation to the stock and bond markets, and often, a relatively high income yield as a response to the historically low interest rate environment. That’s all well and good, provided certain other potentially mitigating factors are properly disclosed and addressed.

Strategies known as Business Development Companies (BDCs) are a good example.  These have become rather popular, with some very large brokerage firms aggressively recommending them to retail investors.  Unlike investing in stock or bonds, the underlying “securities” of these products are often the secured debt of small to mid-sized companies.  Since the strategy is basically investing in commercial credit, and because the legal structure of BDCs requires that most of the net income of the fund to be distributed (similar to a REIT), their yields can be very attractive.

There are challenges however. First and foremost, there can be front end sales fees of up to 10% to buy into the fund, followed by a 2-and-20 compensation model  (that’s a 2% annual management fee and a 20% fee charged on all fund profits).  Regardless of performance, that’s a very expensive investment.  Second, while such funds are publically registered, many are non-traded. That’s right, they’re illiquid:  the person who’s invested in the fund can’t sell it.  The only way the investor can get out of the position is to apply for redemption with the investment company that created the fund.  It’s fairly common that such redemption opportunities are offered on a quarterly basis, with the fund company willing to pay perhaps 90% of the fund’s value to the investor.  And how risky are these investments?  In many cases, the standard methods of measuring risk and volatility don’t easily apply so it’s difficult to know.

We are seeing these in new prospective client accounts more and more often, and in some cases, we would argue they were entirely unsuitable for the investor when they were sold to them. It would probably be an inappropriate investment, for example, for a young IRA owner who has a long time horizon and is seeking capital appreciation through active management in a fee based account.

If an asset or investment product has appeared in your portfolio that you don’t understand, even if it was discussed with you in advance, it’s a good idea to do some research, perhaps with a third party professional to confirm that it’s genuinely an appropriate holding given your objectives.

  • Assets of funds focused on these four areas (real-estate shares, gold stocks, commodities and funds that employ alternative strategies) have soared to $506 billion, up from $172 billion at year-end 2008, according to Chicago investment researchers Morningstar. (Source: WSJ)

A little more about Capital Financial Planners...

Established in 1984, Capital Financial Planners, LLC is an independent, fee-based investment management and financial planning firm located in Salem, Oregon. We provide wealth management and advisory services to clients in the Willamette Valley and beyond. Our services include retirement planning, investment management, advisory services for trustees, hourly financial planning and more. We take a holistic and collaborative approach, working not only as our clients’ financial advisors, but as their financial partners.

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