Choose the Alternative of Alternative Investments

November 1, 2016 | by James Behr Jr & Christopher Paleologus

In continuation of our discussion about which investment vehicles investors should avoid, we will now focus our attention to alternative investments. More specifically, we will discuss the importance of investors excluding Non-traded Real Estate Investment Trusts (REITs), Private Placements, Hedge Funds, Venture Capital Funds, and Private Equity Funds from their portfolios to avoid thwarting investment goals.

A Non-traded Real Estate Investment Trust (REIT) typically consists of a group of real estate properties that are managed with the intent to sell them for a profit in the future. However, unlike REITs, non-traded REITs are, as suggested by the name, not traded on a securities exchange. Due to this nonexistent secondary market, non-traded REITs are quite illiquid by nature and can constrict the financial flexibility of investors. In addition, investors may have limited visibility, if any at all, to the fluctuating value of the fund because non-traded REITs do not trade on a day-to-day basis. As a result, an investor is unaware of the perceived value by the market. Furthermore, non-traded REITs can have fees as high as 15% which can drastically reduce investor returns. Due to the nontransparent nature of non-traded REITs, most investors should exclude them from their investment plans.

A Private Placement is a sale of securities that are not offered through an IPO, but rather through a private offering that is available to select investors as opposed to the open market. Because these investments are associated with companies that are not registered with the Securities and Exchange Commission, public information may not be readily available to investors. Due to this asymmetric information, investors could be investing in high-risk sectors without acceptable corresponding returns. As a result, investors will sacrifice control and insight when investing in a private placement. Private placements do not effectively serve the needs of investors and therefore, should be avoided.

Hedge Funds are professionally managed pools of capital from various investors that are invested in securities and other investment instruments. Hedge funds can have various investment strategies, as determined by the managers of the funds. Hedge Funds are not ideal investment vehicles for investors because they are illiquid. Most hedge funds have a lock-up period in which investors are required to keep their money in the fund. Also, hedge funds typically have high expense structures. For example, a “2 and 20” structure equates to investors paying a 2% fee for their total assets under management (AUM) as well as an additional fee of 20% of fund profits. This high fee structure will reduce investor returns drastically. Investors should rely on other vehicles to fulfill their investment goals.

Venture Capital Funds are funds that manage the money of investors in return for a private equity stake in startups and small-to-medium sized companies with high growth opportunities. Due to the emphasis on early-stage companies, venture capital funds are inherently risky and focus on a long-term time horizon. Because of this, investors should expect to be invested in volatile and risky startups for long periods of time before substantial returns are realized. Also, the valuations of a startup could be inaccurate due to the limited past performance of the companies. As a result, investors could overpay for a fund that is invested in companies with inaccurate valuations and have more potential to incur losses. When it comes to venture capital funds, investors’ best chances could be elsewhere.

Private Equity Funds are investments that are in accordance with the strategies of a private equity firm. Like other alternative investments, private equity funds limit investor insight due to the relatively lax regulation of private equity firms and limited access to performance figures. As a result, investors can unknowingly take on above average risk while earning average returns. In addition to the funds lacking transparency, private equity funds are illiquid. Typically, private equity funds require investment for as long as 10 years. Therefore, investors’ money is tied up and subject to their inherent risks. Avoid private equity funds from interfering with your investment goals.

Alternative investments such as Non-traded REITs, Private Placements, Hedge Funds, Venture Capital Funds, and Private Equity Funds should be avoided by most investors when constructing investment objectives. Alternative investments constitute a threat to sustainable investment performance due to their typically illiquid and costly structures. Because of this, why should investors pay more to earn less?