Alternative Investments Are No Investment Panacea


Financial advisers need to know that dangers lurk in the complex world of alternative investments and they must disclose these dangers to their clients. At present, many investment advisers are under pressure to sell alternative investments and are doing so in greater numbers than ever before. Alternative investments can include virtually any investment that is not a traditional stock or bond, such as gold or currency to mutual funds that employ hedges, leveraged exchange traded funds, options, short-selling, derivatives and nontraded REITs (“Stern Advice-Investors pressed to go alternative,” by Linda Stern, Reuters). “A majority of advisers — 66 percent of a mix of commissioned brokers and fee-only advisers — are inclined to employ alternative investment strategies, even for middle market clients,” according to the article, citing a study released earlier this month by Natixis Global Asset Management.

Unfortunately, few sellers of alternatives have an in-depth understanding of these complex products and are thus unable to explain the risks to investors. Many alternative investments use derivatives and options to try to achieve their goals. It takes an expert to understand how they work. For instance, options are priced using a complex mathematical formula than won its creators a Nobel prize.

As a group, alternative investments lack a ready secondary market and therefore tend to be illiquid. Moreover, some of them (private equity, natural resource limited partnerships, and real estate) have lengthy lock?up periods during which sales are prohibited.

A major driving force behind the effort to sell alternative investments is the high fees associated with them. Hedge funds, for example, were dubbed by Warren Buffett as “manager compensation schemes.” Alternatives also come with high expenses. Consequently, it takes an extraordinary return just to break even.

Some alternative investments like structured notes put the investor’s principal at risk. Investors in so-called “100% principal protection” notes issued by Lehman Brothers lost almost all of their value after Lehman’s bankruptcy. It turned out that the notes, which were sold by other firms, were really just the unsecured obligations of Lehman Brothers.

Investors should beware of the hype associated with alternative investments. They are too risky and complex for most investors.

Page Perry is an Atlanta-based law firm with over 170 years of collective experience maintaining integrity in the investment markets and protecting investor rights.