Alternative Investments – Big Problems

 

According to financial advisers, do not be fooled by the recent market in stocks into believing that we are in for a continuing period of sustained low volatility.  Those advisers want you to expect lots of volatility and market corrections and to invest accordingly.

In light of the foregoing, investors should adopt alternative investment strategies according to many such investment advisors (“In praise of alternatives,” InvestmentNews). The author says his firm “offers the nation’s largest lineup of alternative ETFs,” and he advocates asset classes and strategies such as “real estate, commodities, precious metals, currencies, volatility, and private equity; and strategies that are dynamic and focused on absolute returns, such as equity long/short, relative value, and merger arbitrage.” He claims that investors need them “to build modern portfolios capable of weathering [future] market storms.”

Yet, almost in the same breath, he admits that investing, especially using his brand of alternative investing, involves risk, including the risk of not weathering market storms and possible loss of principal.  He further admits that the alternative investment products he advocates and sells are non-diversified and entail substantial risks associated with the use of derivatives (swap agreements, futures contracts and similar instruments), imperfect benchmark correlation, leverage and market price variance, and that the materialization of these risks should be expected to increase volatility and decrease performance.

The truth is that alternative investments are not a panacea for conditions of market volatility and corrections.  For the reasons the author identified (lack of diversification, over-concentration, use of derivatives and leverage, lack of appropriate benchmarks to analyze performance), most individual investors would be well advised to be skeptical when receiving sales pitches involving substantial investments in alternative investments.   Some other reasons for wariness include the following risks and problems associated with alternative investments:

•    Illiquidity (Although ETFs are market traded, niche, leveraged and inverse leveraged ETFs may have significant liquidity problems. Non-traded alternative investment products, such as non-traded REITs, are illiquid.)

•    These complex, non-conventional products lack transparency in pricing and operation, and are often not fully understood by the investor or the seller, as evidenced by the seller’s inability to explain how the investment works to an arbitration panel.

•    Valuation problems (Traded ETFs often trade at significant premiums or discounts.  Non-traded alternative investments are valued using models and guesswork, and sometimes are fraudulently valued.)

•    Expensive fee structures decrease returns on investments.

Alternative investments remain on regulators’ radar screens because of these inherent problems and because of sales practice violations. The Financial Industry Regulatory Authority (FINRA) has long been concerned with sales practices relating to alternative investments (see e.g., Regulatory Notice 03-71 Non-Conventional Investments), and has found it necessary to regularly remind members of their obligations when selling them.

Page Perry is an Atlanta-based law firm with over 150 years of collective experience maintaining integrity in the investment markets and protecting investor rights.