Alternative Investments: “Do They Belong in My Portfolio”.
Be very careful in evaluating and making alternative investments. By following some specific rules you can increase your chances of a profitable outcome.
Copyright 2008-2010 Robert S. Hockett, CFP All rights reserved

Robert Hockett is a fee-only wealth manager and financial life coach. He founded Cambridge Southern Financial Advisors in Atlanta, Georgia, in 1996 to provide comprehensive fee-only wealth management services for successful licensed professionals, business owners, and executives, and currently has clients in 14 states. A former Assistant Vice President with Wachovia Bank’s Private Financial Advisory Group, Robert has worked with over 300 attorneys and twenty law firms during his career. Widely regarded as an expert on financial topics, he has been quoted, or his clients have been featured, in The Washington Post, Smart Money, Physicians Advisory, INC Magazine, Financial Advisory, Investment Advisor, The Smart Money Guide to Real Estate Investing, and Business Week Online. Robert graduated from Brigham Young University, holds the Certified Financial Planner (CFP) designation and is a Registered Advisor with NAPFA. Contact: robert@cambridgesouthern.com or visit:

www.Cambridgesouthern.com

In the past 8-10 years hedge funds and alternative investments have garnered world wide praise on one hand, as well as, world wide scorn on the other. In this financial planning column, we will look as several different types of alternative investments and give you some basic guidelines to enable you to answer the question: “Do alternative investments belong in my investment portfolio”?

This discussion of alternative investments is in part a response to the recent turbulence in the financial markets. In our practice, we have reviewed many more alternative investments for clients than normal as investors try to generate positive return on investment in uncertain times.

Let us first define what we mean by alternative investments. It is easier to define alternative investments in terms of what they are not rather than what they are. Alternative investments are those financial investments that are separate from and which act differently from New York Stock Exchange/American Stock Exchange/NASDAQ Traded common or preferred stocks or municipal/corporate/or US Treasury bonds. They are also different from Real Estate Investment

Trusts(REIT’s) which are traded on national exchanges like mutual funds. Whether individual stock shares or bonds as mentioned above or REITS or in the form of pooled investments like equity or bond mutual funds, all of these are often called “conventional” investments. Most of the attention in individual attorney’s investment portfolios needs to be paid here. In our opinion, conventional investments should make up between 90-100% of the attorney’s total investment portfolio.

For many individual investors, alternative investments are totally inappropriate. We do not usually recommend them to any client with investment assets under $1,000,000. For any client under $10,000,000 in investment assets we recommend no more than 5% in total alternative investments. From a rational investment approach, alternative investments are designed to do one thing in an investment portfolio – add additional diversification. The way that they do this is provide exposure to an investment area or “class” that is non-correlated to the other”conventional” investments in the portfolio. So while most individual investors should avoid alternative investments, all should know something about them. We should start with a discussion of correlation and diversification.

Investment Correlation and Diversification:

Let’s discuss correlation in an investment portfolio in a simple way:

Positive Correlation is the movement in the same direction of two or more individual investments or classes of investments. For example, pick the two biggest oil company stocks. If one is up in share price the other stock is probably up as well. They are similar enough to move in closely the same direction - both up and down in the market with the same market conditions. As they are more positively correlated…they may move in the same % as the other - either up or down as the case may be.

Inverse Correlation is the movement in the opposite direction between two or more individual investments or two or more classes of investments. With the above example of two oil company stocks let’s introduce a probable inverse correlation – an airline stock. As the price of oil increases so do the profits of oil company stocks, the cost of oil increases and therefore airplane fuel also increases. This cost increase raises costs for airlines and therefore puts downward pressure on their profits. This drives airline stock prices down. So oil company stocks up –airline stocks down- an inverse relation.

Non-Correlation is the absence of a pattern of correlation in either a positive or negative direction. A long-short hedge fund may have no correlation to either oil stocks or airline stocks unless the fund exclusively focuses on either type of stock - excluding all others. There is no coherent pattern of correlation.

In building investment portfolios a wealth manager seeks to have both positively and negatively correlated investments. This way when one part of the portfolio is down another part is up. This relationship lowers the total volatility or variability of the portfolio. Non-correlated investments also provide a positive benefit in the construction of an investment portfolio because, when added to all of the other investments, it lowers the volatility of the aggregate portfolio. Since volatility is synonymous with risk, additional diversification lowers volatility, and therefore lowers risk. When alternative investments are used correctly, they can lower the overall risk profile of the investment portfolio as a whole –even when they themselves may have a higher than average risk.

While this makes a case for alternative investments from the side of diversification, it does not address some of the inherent problems and challenges in selecting among alternative investments as its own asset class.

Different Types of Alternative Investments:

While there have been many books written on Alternative Investments, I will explore briefly several types of alternative investments. This list is by no means exhaustive and only touches on the most common:

Hedge Funds

These are funds that pool investors’ money who typically have one person or a small group of persons who provide investment guidance in some very specialized areas of the investing universe.

Strategy Specific Hedge Funds: Generally stay focused on one specific area such as currency futures (dollars vs. Euros vs. yen), collateralized mortgage debt (Billions were lost recently in this strategy) long short
funds (going long on some stocks while short on others to play market turbulence – while interest in the specifics of the underlying stocks is agnostic).

Opportunistic Hedge Funds: Generally focus only on making money- they may move around in a wide range of different areas depending on where they feel they can make money. The goal is only to make money the specific strategy is secondary. These are the hardest to evaluate since there is a high probability that investment performance is situational and will be therefore impossible to duplicate.

Venture Capital Funds

Venture Capital Investments: Are generally well known as early stage investments in small or medium sized companies. Since the highest percentage ownership comes the earlier that the investment is made, these tend to be risky investments. The small business is often helped by experienced managers that are hired by the VC fund, grown to some sort of profitability and then sold to a strategic industry buyer or sold through an initial public stock offering. The more successful funds tend to focus on a specific type of industry be it technology, biomedical, or now alternative energy. The objective is to make say… 10 investments that are projected to make 20-40% annually. The reality is that 6-7 will fail, 2-3 may break even, and 1 might do really well. This way the one big success makes up for the failures and the fund makes money overall. The best key for success is to only invest in tried and true VC teams that have a long and proven track record. This is because brand new VC firms may be 3-5 years old and still not have proven themselves since the building of companies and the development of exit strategies is often a multi-year process.

Barely Public Companies
Barely Public Companies looking for Capital: These are companies that
are trying to more along the product cycle and enter a new marketing channel, develop or launch anew product…all of which are reported to “make the company move to the next stage”. These companies are usually in a precarious situation. One that I reviewed recently was loosing so much money that if the round of additional money was not found in a several week period, the company would go bankrupt. These are usually power point presentations presented by someone who has funded the company already and has a lot to loose if they do not get additional funding immediately. These are one of the most risky types of alternative investments. They have high overhead, and are not usually as lean as they could be…this is the reason they are out of money. They usually represent a great idea that was not previously executed well with the available resources. Now the resources are counted in months if not weeks. The investment will either help carry them through the rough spot – but this alone does not insure that they will execute strategy well or they will not call you 4 months after your initial investment and tell you how much you just lost. The key is to make sure that any money you decide to invest is NOT paying out any earlier investors, that the company has a sound business plan, and most importantly that the numbers make sense. Be very cautious of the financial assumptions - which are at best positive spin and at worst completely unrealistic fabrications. I recently saw one that had a future sales projection that went from a $3,000,000 annual current loss to a $40,000,000 annual profit in 4 years with a 5,000% increase in top line revenue …all in 4 short years. They had already been in business for 5 years.

Family and Friends Funding
Family and Friends Adventure Capital: This is still how most small businesses raise their investment money. The risks are obvious, lack of business expertise, lack of financial controls, lack of liquidity, lack of industry knowledge. There are millions of small businesses which have been funded this way and succeeded ... as there are additional millions who have been funded this way and failed. Our advice is to ask three questions.

• Can you afford to loose the money?
• Did you select a section 1244 election in the incorporation documents? (The last time that I checked this would allow you to take a loss against ordinary income instead of against capital gains plus $3,000 per year).
• Is everything in writing?

Are they working with a Small Business Administration (SBA) lender who will require them to write a business plan, and pledge personal guarantees and their home equity as collateral. There are few more powerful incentives to full mental concentration than to loose your home if you are wrong. Be very careful of the friend or relative who is eager for you to risk a significant amount of money that will not put their own money on the line unless they have a history of successful “deals”. I have seen would-be small business owners who refused to pledge their own homes to the SBA but were quite happy to ask our clients to use their significant investments or even if they were already fully allocated, to borrow to fund their proposed business.

Real Estate or Lending Partnerships or LLC’s
Real estate partnerships: Partnerships have raised money through small offerings for a very long time. These partnerships or in the last 15 years LLC’s usually have a managing member which is another partnership who has significant experience in the real estate development, management, redevelopment, or entitlement process. Money is pooled and used to purchase, develop or redevelop real estate in the areas of commercial, residential, retail, or industrial properties. These partnerships as also used to purchase raw land and complete often complex zoning requirements. These investments are often for fixed periods of time typically 5-7 years. The specialized benefit is added to the property by the subject matter expert (the managing member) and then when realized by the larger market the property is liquidated and the original investment is returned to the investors with appreciation. In the case of developed properties, there is often a quarterly dividend of a percentage of the rental income from the properties paid to the investors.

A variation on a theme is the use of partnerships to fund, lending pools to other real estate projects. While partnerships have done this for many years, there have recently sprung up a rash of fraudulent smaller “lending pool” partnerships. These are also called “Hard Money Loan Pools”. Any investor should be very wary of any investment that promises to pay out 2-5% PER MONTH in these partnerships. We recently had a client who did not follow our advice loose $100,000 in one of these fraudulent partnerships. There were others who lost a total of $31Million in this same partnership in the mid-west. The key is to work with someone whom you trust who also has a track record for successful partnerships. There may well be more opportunity in the future in this area as credit is tight and banks are not as willing to lend.

Five Challenges of Alternative Investments

Selecting among different individual investments requires evaluating the specific merits of each and filtering down to an investment that makes sense for each individual, so also does selecting among alternative investments. This asset class is among what may be the most complicated asset class in modern investing. Proper selection requires research, due diligence and significant amounts of caution. Let’s review the five greatest challenges of alternative investments.

Challenge 1) The lack of transparent information on the investment strategy.
This research and evaluation is similar to what many investors did at the turn of the century. The information on alternative investments is not transparent and each fund or investment interest keeps information very closely guarded so that other alternative investment managers or hedge fund managers do not use this information to benefit themselves or to trade against their competitors. Most offering memorandums range in size form 80-200 pages. Each is vague on specific details of the investment strategy while outlining all of the ways the investment may fail and limiting the offering entity’s liability should the investment strategy fail.

Challenge 2) The lack of regulatory oversight.
Much of the alternative investment universe is either thinly regulated or virtually unregulated. Historically, government regulators only allowed the wealthy to invest in most forms of alternative investments reasoning that the wealthy were by definition sophisticated and therefore would have their attorneys and accountants review each deal and provide their own due diligence. Since they were wealthy, they could also afford to loose money and still be fine financially. The regulators set very specific “accredited investor” guidelines. Fortunately or unfortunately, most attorneys who have been in practice for 10+ years now qualify as accredited investors based on their income and their total net worth.

The reason that this might be viewed as unfortunate is that the original “accredited investor” guidelines were not indexed for inflation. As my revered grandmother once said “a million dollars is not what it used to be”. This “wealth inflation” allows many attorneys to “play” in an area once reserved for the ultra affluent. While this is fine in that it gives us all many investment options, the alternative investment area is also one of the riskiest and least regulated.

Challenge 3) The broad nature of the definition of “Alternative Investment”
By its very title as an asset class, an “alternative investment” is anything other than a “conventional” stock or bond or a mutual fund. It is very easy to get lost in the complexity of the world of alternative investments. Most investors begin to focus on a specific subset of the “alternative investment world - if for nothing else to whittle down the options from which to select.

Challenge 4) The high fees and high minimums inherent in the nature of alternative investments.
Because of the individual nature of alternative investments, they often require more employees to execute strategy. There may be a group of business experts who research problems in the market segment, desks of currency traders etc. There are often annual fees that range from up to 2-5% of the assets annually. There is also often a success fee in addition to the annual fee that can range from 20-50% of the growth of the investment annually or upon distribution. There may often be high minimum investments – ranging from $250,000 - $5,000,000 per investor.

Challenge 5) Illiquid Investments – Easy To Buy – Hard To Sell
For the most part alternative investments are either thinly traded – meaning that there are a very small number of buyers and sellers at any one time, or they are not traded after the initial investment. Some alternative investment funds will allow you to redeem the investment IF they have the cash on hand - but only at a discount to the original purchase price - often 15-20% less that you originally paid. When a fund does not have its own redemptions and when an investment is thinly traded or not traded at all, the individual owner may actually have to find someone else to buy the investment from them. They may not be able to rely on a stock broker or other “market maker” to sell his or her shares. This is often called “the greater fool” method of selling an investment. You must locate someone more foolish than you to whom you can sell the investment. There is a very real problem of disclosure and liability if you are selling your investment to another persona in a secondary sale. Generally, once you buy an alternative investment you own it for the duration of the investment period.

Conclusion
Alternative investments can bring additional diversification to an individual’s investment portfolio. Selecting among different individual investments requires evaluating the specific merits of each and filtering down to an investment that makes sense for an individual, so also does selecting among alternative investments. This asset class is among what may be the most complicated asset class in modern investing. Proper selection requires research, due diligence and significant amounts of caution. Always keep in mind that more than a 5% allocation of your total portfolio to all combined alternative investments may exceed your total risk tolerance. Alternative investments are an important part of wealthy client’s asset allocation. They should be used judiciously and with ample caution and never with money that may be needed within short periods of time. And finally, anything that looks to good to be true is probably false.