Investors should use extreme caution before investing in alternative investments. Alternative investments have become the popular “investment du jour” but these investments are fraught with risks. Simply stated, alternative investments are not the panacea that so-called experts represent them to be. For the reasons discussed below, investors need to be very skeptical of any recommendation encouraging them to invest in alternative investments.
Most alternative investments share the following characteristics: they are extremely complex; they are opaque not transparent; they have very little liquidity; they have expensive fee structures; and they are not understood by most brokers and investors.
InvestmentNews recently published an article entitled: “Every adviser should be invested in alternatives: Investment experts.” Brokerage firms have sold billions of dollars of alternative investments in recent years, as low returns and high volatility have driven thousands of investors away from traditional investments.
The National Securities Administrators Association (NASAA), an organization of state securities regulators, publishes an annual list of Top Investor Traps and Threats. This list is composed almost entirely of various alternative investments. Among the risks of which NASAA warns are the risk of dishonest promoters selling ponzi schemes and other outright frauds, nondisclosure of facts that would make a reasonable investor say no to the investment, and sales of commodities like gold that have already had a significant run up in price.
History shows that alternative investments are flawed investments:
They are illiquid investments with long lock-up periods making them hard to cash out.
They are complex and opaque, making them difficult for brokers and investors to understand how they work and what the risks are.
The upside potential is exaggerated because of extraordinarily high fees and expenses. For example, according to Morningstar, alternative long-short funds had an annualized loss of 1.17% over the past three years versus a 0.02% annualized gain for the S&P 500 stock index. From January 1 to July 22, when the S&P 500 rose 8.1%, the average long-short fund rose just 1.25%, missing out on 15% of the broad market’s rise.
Claims of downside protection are misleading. They have to make risky bets to earn the same return as index funds net of fees and expenses. They often use risky derivatives and leverage, and dangerous strategies such as going short – i.e., selling a security you do not own and hoping to buy it back later at a lower price.
Claims that they are not correlated with traditional stocks and bonds are often false. For example, many hedge funds crashed along with the stock market.
Despite these flaws, recent business press reports indicate that brokerage firms are selling alternative investment at a very high rate. They are capitalizing on investors’ fear of the stock market and frustration with low returns on traditionally safe investments like CDs and money market funds.
Investors who may be considering an alternative investment should read a book called “The Only Guide to Alternative Investments You’ll Ever Need ? The Good, the Flawed, the Bad and the Ugly,” by Larry E. Swedroe and Jared Kizer, which puts most alternative investments in the flawed, bad and ugly categories.
Page Perry is an Atlanta-based law firm with over 150 years collective experience representing investors in securities-related litigation and arbitration. While past results are not indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 45 occasions. For further information, please contact us.