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Are "Alternative Investments" Only For The Rich?

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
July 25, 2006

IN THIS ISSUE:

1.  Defining The Many “Alternative Investments”

2.  Hedge Funds, Futures Funds & Many Others

3.  Some Precautions About Alternative Investments

4.  Mutual Fund Companies Get Into The Act

5.  Separating The Good from The Bad 

6.  Conclusions & Other Options

Introduction – A Look At So-Called “Alternative Investments”

Ever since the wrenching 3-year bear market of 2000–2002, investors have been flocking to so-called “Alternative Investments” (especially hedge funds).  Once a relatively small and obscure industry, it is estimated that hedge funds and other alternative investments now account for over $1 trillion of investor assets.  In the second quarter of 2006 alone, hedge funds took in over $42 billion of investor assets according to Hedge Fund Research, Inc.

For those investors who qualify, most Alternative Investments seek the potential for gain in various market environments, but also claim to provide risk management techniques should major market corrections occur.  The problem is that the “Alternative Investments” umbrella covers a very wide range of investment programs and strategies, some of which involve relatively moderate risks and some of which are extremely speculative and volatile.  Unfortunately, it’s not always easy to tell one from the other.

In this issue of the Forecasts & Trends E-Letter, I will begin a multi-part discussion of Alternative Investments.  I will generally define what they are, some of the more common strategies, how they are sold, and to whom, and some of the pros and cons of adding these investments to your portfolio.

If you are not familiar with such investments as “hedge funds” or “private equity funds” or “managed futures funds” and other different investment options, then this series on Alternative Investments, is must reading for anyone considering such additions to their portfolio.

Like my multi-part series over the past two months on the “Mutual Fund Merry Go-Round,” this will be another series of hopefully very educational articles on the Alternative Investments marketplace, including a detailed discussion on hedge funds, which have become increasingly popular among sophisticated investors in recent years. 

Even if you don’t need the information today, you will have it for future reference.  As with my earlier “Mutual Fund” series, I am waiving my copyright, and you may share this information with others (with proper credit given, please).  Also keep in mind that many Alternative Investments can be quite risky, and are not suitable for every investor.  You should not consider this article to be investment advice, and I am not recommending any of these investment products for you personally.  A thorough understanding of the specific risks of each type of Alternative Investment is a must when considering them for your portfolio.

Defining “Alternative Investments”

One of the biggest challenges for this article was coming up with a concise definition of Alternative Investments.  And more generally, what are these complicated investment vehicles an alternative to in the first place?  Some ultra conservative investors might consider stocks and mutual funds to be Alternative Investments when compared to fixed-income investments such as certificates of deposit or fixed annuities.

On the other end of the spectrum, very sophisticated investors may not consider many of the investments that I will discuss to be Alternative Investments, since they deal with them all the time.  After poring over volumes of materials on this subject, the best definition of Alternative Investments I can come up with is “investments that, either due to their complexity, structure, risk factors and/or large minimum investment requirements, are not generally suitable to the public” - meaning in this case, the average investor.

Complexity is typically a limiting factor when considering Alternative Investments, as I will discuss below.  Structure refers to how the investment is offered.  Many Alternative Investments are sold in the form of “private placements” which are generally available only to wealthy investors.

My List Of So-Called Alternative Investments

My basic list of Alternative Investments would include: hedge funds, private equity offerings, currency funds, managed futures funds, direct participation programs (limited partnerships), and other funds that use derivatives.  This list would also include funds that primarily use options, futures, straddles, leaps, precious metals (bullion or shares) or other such investments that require a detailed knowledge of the applicable instruments and markets to have a chance to be successful. 

Some sources also consider artwork, antiques, classic cars and even fine wines to be included in the definition of Alternative Investments.  I would agree that these are an alternative to traditional equity and bond investments, but they also require a high level of related expertise to be successful.  The ability to accurately evaluate the condition and authenticity of these items is extremely important.  As a result, I personally consider these items to be “collectibles” rather than Alternative Investments, though some do have the potential to appreciate in value.

Because the term Alternative Investments encompasses such a wide variety of offerings, I must limit my discussion of the various types to a few major categories.  If I tried to discuss each and every conceivable type of Alternative Investment, this series of E-Letters would stretch to book-length proportions. 

In the weeks ahead (not every week, mind you) I will focus on those Alternative Investments that I see getting the most attention from investors, including hedge funds, private equity, managed futures funds and a few others.  In this issue, however, I will concentrate on some basic things you should generally know about ALL types of Alternative Investments.

Some Precautions About Alternative Investments

With any type of investment, it is important to know all of the risks before committing your hard-earned dollars.  As a general rule, Alternative Investments carry all of the standard investor requirements and risks of traditional equity and bond investments.  In addition, there are specific requirements and risks associated with Alternative Investments that you should be aware of.  Here are some key points to consider.

  1. As I stated above, most Alternative Investments are not available to everyone.  Many Alternative Investments are private offerings available only to “sophisticated investors.”  In general, to be sophisticated you must qualify as an “accredited investor” as defined by SEC guidelines.  To meet these guidelines, in general terms, you must have a net worth of at least $1 million in assets, or have income over $200,000 per year (last two years and expectation of same this year), or both.  There are even some offerings that require you to have over $5 million in assets to qualify.

    To satisfy the requirements, you must be prepared to share your personal financial information with the sponsor of most Alternative Investments, since that sponsor is responsible for making sure that offerings are made only to those who qualify as accredited investors and that the investment is suitable for you.  If you don’t like sharing information about your personal finances, then Alternative Investments are probably not for you.

  2. Because Alternative Investments are usually suitable only for wealthy investors, the minimums required to invest in many of these programs can be considerable.  It is very common to see the required minimum investment be $100,000-$250,000 on the low side, with many requiring investments of $1 million or more, and some at $5 million or even more.

    Private offerings are also usually limited as to the number of investors they can take.  In many cases, only 100 investors can invest in any one of these private offerings (funds), so by the time you learn of an Alternative Investment, it may be fully subscribed.

  3. If you do qualify as an “accredited investor,” there is a presumption (right or wrong) that you are better able to discern between good and bad investments than the average investor.  Therefore, private offerings have less regulatory scrutiny than public offerings.  That means that you will need to read the Private Offering Memorandum (prospectus) and other offering materials very carefully and ask lots of questions if there is something you don’t understand.  It is also imperative that you check out the background of the sponsor of any private offering you are considering.

    It is also important to check out the asset manager of the private offering you are considering.  It is estimated that there were over 8,500 hedge funds in existence at the end of 2005, up from apprx. 4,000 at the end of 2000.  You have to wonder where these 4,500 new asset managers came from.  Did they come from a successful career in the mutual fund industry?  Have they managed other hedge funds previously (or currently), and were they successful?  Or, is this a relatively new venture for them?  Thus, it’s very important to ask about the background of the asset manager when considering any Alternative Investment. 

    Recently, the SEC and other securities agencies have been looking at regulating certain types of Alternative Investments, including hedge funds, more closely to both reduce the chances of fraud and limit access to these investments to those who are truly suitable for the risks they carry.  However, even with increased regulation, the Alternative Investments industry is still one where “caveat emptor” (ie - buyer beware) is a most appropriate caution.

  4. Most Alternative Investments have fees that are considerably higher than those related to stocks, bonds and mutual funds.  It is not uncommon for hedge funds or other alternatives to charge a 1-2% annual management fee, plus a so-called “incentive fee” equal to 20% (or more) of the trading profits.  As a result, there are two important things (among others) to remember in relation to Alternative Investment fees.

    First, it is important that you analyze “fee-adjusted numbers,” meaning that the past performance record is calculated “net” of all fees and expenses.  To determine whether you are looking at performance that is after all fees and expenses have been deducted, you will generally have to review the fine print disclosures below the performance tables (if any) and in the accompanying marketing material. 

    Second, don’t let the fee structures, alone, make your decision.  Today, many investors make a decision on a mutual fund based primarily on its fee structure.  The financial media has gone a long way to help this idea along by praising low-fee funds and demonizing those that charge more.  However, what really matters at the end of the day is how much money you have in your pocket.  Some Alternative Investments have historically produced higher net returns that added value beyond the fees they charged.

    Related to this discussion about fees is the subject of hedge “funds-of-funds.”  In this type of hedge fund, the trading manager seeks to identify other successful hedge funds, and then makes secondary investments in those funds.  The potential benefit of this approach is that the investor gains a diversification among various types of strategies, but one of the downsides is that there is another layer of management/administrative fees at the secondary fund level. 

    Thus, not only must the underlying fund managers add value over and above their fees, but the fund-of-funds manager’s selection process must also add value.  It’s quite a high hurdle, in my opinion, but some managers have done it successfully, and hedge funds-of-funds continue to be popular among wealthy investors.

  5. Many Alternative Investments are very illiquid.  Many hedge funds and other Alternative Investment funds have very restrictive policies for getting your money out.  Many only allow redemptions once or twice a year; some allow quarterly withdrawals.  There is usually no market for these securities, so you can usually only get your money out when the fund has adequate liquidity (cash) to permit redemptions.  Thus, you must understand the illiquidity issues going in and consider such investments only for the long-term.

  6. Generally speaking, no single type of Alternative Investment should amount to more than 10-15% of your overall portfolio.   Most legitimate investment sponsors will recognize the need to limit your exposure to these riskier investments to a small part of your overall portfolio.  As discussed above, most will ask many questions about your personal financial situation.  However, there are others who would recommend that you put most or all of your life savings into these investments.  In such cases, just say NO!

  7. Even though some Alternative Investments, especially some hedge funds, can show a history of positive returns with very small losing periods (including no annual losses), I do not consider any Alternative Investment to be compatible with a truly conservative investment strategy.  These products should only be considered by investors willing to take on higher risks with the potential for higher rewards.

  8. Finally, the standard rule of investing still applies to Alternative Investments, just as it does to all others: If it sounds too good to be true, it probably is.

    Unfortunately, there are unscrupulous investment sponsors who are actively promoting ultra-high-risk and/or bogus investments in an effort to attract investors who are scared of the stock market but are frustrated with the small returns on low-risk investments like CDs or fixed annuities.  Others promote legitimate investments, but often overstate the potential benefits and/or understate the risks of the alternative strategies.

    Before we move on in our discussion of Alternative Investments, here are some quick guidelines from the SEC on how to spot investment fraud:

    1.  Be wary of promises of quick profits, offers to share “inside” information, and pressure to invest before you have an opportunity to investigate.

    2.  Be careful of promoters who use “aliases.” Pseudonyms are common, especially on the Internet, and some salespeople will try to hide their true identity. Look for other promotions by the same person.

    3.  Words like “guarantee,” “high return,” or “as safe as a C.D.” or “limited offer,” may be a red flag. No financial investment is “risk free” and a high rate of return means greater risk.

    4.  Watch out for offshore scams and investment opportunities in other countries. When you send your money abroad, and something goes wrong, it's more difficult to find out what happened and to locate your money.

Mutual Fund Companies Get Into The Act

As I have noted, Alternative Investments have become very popular, but marketing restrictions generally keep them out of the reach of the average investor.  Never to let an investment demand go unserved, the mutual fund industry has been busy over the last couple of years trotting out new specialized mutual funds that seek to employ active management strategies that are touted to be similar to those used by hedge funds.

The result is that the average mutual fund investor can now include in his or her portfolio funds that do more than seek the best stocks to own or mimic an index.  At present, there are mutual funds that can go both long and short, funds that are always short the market, funds that provide leveraged returns, so-called “market-neutral” funds, and a host of other hedge fund-like strategies.

Is this the opportunity non-accredited investors have been waiting for?  Maybe, and maybe not.  Keep in mind that many of these funds are relatively new, or brand new, with managers who have little actual experience using these hedge fund-like strategies, and it remains to be seen if they can replicate the returns of the actual hedge funds they seek to emulate.  While the marketing materials for such funds discuss the potential value of these strategies, there is a distinct difference between perceived value and actual returns.  Time will tell.

As these new mutual funds begin to produce actual track records, it is entirely possible that some will prove to be successful, and average investors will be able to access complex investment strategies once available only to the wealthy.  Even so, it is important to remember all of the advice I have provided above when considering these investments.  Some investors see a mutual fund as being somewhat less risky than a hedge fund.  However, if the mutual fund is using a hedge fund strategy, it may be just as risky as the type of hedge fund it seeks to imitate, (or in some cases, maybe even more so).

My company has been closely following the development of these hedge-type mutual funds, and I have noticed a couple of important things.  First, many of the earlier attempts at this strategy were not successful and were subsequently closed.  This means that any research you might do on these hedge-like funds may have a great deal of so-called “survivorship bias.”  This happens when a particular category of investments, taken as a group, looks better than they should because the results of funds that no longer exist and therefore are excluded.

The other thing we have noticed about the mutual funds with three years or more of actual track record is that some of them have historically produced consistent levels of positive returns (“absolute returns”), and they tend to have a lower level of correlation with the overall stock market than some other types of funds.  For this reason, we have analyzed these funds closely and have included some of them in our new Absolute Return Portfolios that I have recently written about.  See more on this below.

Separating The Good From The Bad

In one sense, Alternative Investments are no different from most other classes of investments: there are good choices and there are bad ones.  This is true regardless whether you are looking at private placements offered by independent sponsors or hedge fund-like mutual funds offered by well-known fund families.  The bottom line is, you have to do your homework.

One thing you should never do is invest in any particular strategy just because it is the latest  “hot” investment that is being touted on the financial news shows and in investment publications.  Blindly following suggestions given on these shows and in magazine articles is almost a sure recipe for investment disaster.   In the case of Alternative Investments, as with any investment, these strategies should be consistent with your overall financial goals and risk tolerance.

Determining whether Alternative Investments are suitable for you may or may not be something you feel comfortable doing for yourself.  Many of these products employ complicated strategies and involve numerous hard to quantify risk factors, in addition to limited liquidity as discussed above.  Thus, most investors would be well advised to seek out the services of a qualified Investment Advisor to help evaluate any Alternative Investment that they are considering, especially if this opportunity came your way as a result of a telemarketing call or the Internet.

Please understand that my intent here is not to turn you off to Alternative Investments.  Far be it!  In fact, my company has sponsored various Alternative Investments for years.  We have been active in helping investors determine whether such investments may be suitable for them for many years.  We can do the same for you as discussed below.

The point is, as noted above, there are good Alternative Investments and there are bad ones.  Unfortunately, you may never hear of the good ones, either because they are closed to new investment or they don’t actively market their funds or services.  But they are out there if you know how to find them, or if you use professionals to help you find them.

Conclusions & Other Options

There are Alternative Investments that offer good opportunities to participate in different markets and different investment strategies which are not available to the general investing public.  But it is important to keep in mind that while these alternatives may offer higher return potential, they also involve special risk factors that must be taken into consideration.  Above all, you MUST understand the risk factors and your own tolerance for that type of investment.

Many of my clients are high net worth, sophisticated accredited investors.  As such, I advise them to consider Alternative Investments as a part of their asset allocation and active management strategies.  Just as no single stock sector always has the highest performance, no single Alternative Investment outperforms the market and its peers all the time. As always, diversification is the key to a successful portfolio. 

For those of my clients who do not meet the definition of an “accredited investor,” we now offer our Absolute Return Portfolios which are made up of carefully selected mutual funds which have demonstrated hedge fund-like performance characteristics.  We offer three different Absolute Return Portfolios which are structured to meet certain risk/reward desires among our many clients.

Fortunately, our Absolute Return Portfolios only require a minimum of  $10,000 to invest.  I think it’s a good way to get exposure to absolute returns and active management, without betting the farm.  They are also a good way to get your children or grandchildren involved in investing.  If you would like to learn more about our select mutual fund Absolute Return Portfolios, just CLICK HERE to request more information.

In the next installment of this Alternative Investment series (in the next few weeks), I will discuss hedge funds – one of the most popular and fastest growing investment areas in recent years – in greater detail.  If you have heard about hedge funds, but aren’t sure just exactly what they are, I will attempt to enlighten you (pros and cons) with the next issue in this series.

In the meantime, if you have questions about Alternative Investments, or if you have an existing Alternative Investment that you would like to discuss, just e-mail us at mail@profutures.com or give one of our Investor Representatives a call at 800-348-3601.  We will be happy to tell you if we are familiar with the type of investment, and what the pros and cons may be.  This service is free of charge with no obligation whatsoever.

Wishing you a great summer,

Gary D. Halbert

 

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FYI, Bill Clinton was also tight with Enron's Ken Lay.
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Forecasts & Trends E-Letter is published by Halbert Wealth Management, Inc. Gary D. Halbert is the president and CEO of Halbert Wealth Management, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, Halbert Wealth Management, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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