Alternative Investments: Not So Alternative Any Longer
Back in the day - did I just say that??? - individual investors with small portfolios were limited to owning individual stocks or bonds. Over time that has changed.
Today we are inundated with investment options and are told they can help add to both your expected returns and the diversification of our portfolios. Often mentioned are alternative investments, which covers investments like hedge funds, venture capital, and private equity.
I believe that one should always be wary of things packaged as “new” by Wall Street, and especially be careful when something is touted as a new type of investment.
In reality, there are only two fundamental ways to invest, either you invest as an owner (buy equity), or as a creditor (sell debt).
For all the bells and whistles purported as enhancements, in reality, alternative investments boil down to different strategies surrounding stock or bond ownership. That doesn’t invalidate their potential uses, you just need to make sure you know what you are buying.
Take “hedge funds” for instance. I would contend that the term “hedge fund” tells you nothing about what you are buying, except the fund is charging you fees in a different manner.
Up until recently, Registered Investment Advisors, like Nicollet, were prohibited from charging clients a fee based on performance; it’s the law.
Hedge funds were created to get around this SEC rule.
The first managers offering hedge funds were professional investors who’d developed a reputation for their investment prowess. To shed themselves of performance fee restrictions, they started funds unregulated by the SEC.
The funds were typically private and offered only to qualified investors. Unencumbered by performance fee restrictions, the funds charged both an annual fixed management fee (for pens, paper, and coffee) and then a performance fee.
Typically, the fund would pay the managers a fixed percentage of the gains above some threshold minimum return.
A few years later the term “Hedge Fund Billionaire” was coined.
It’s important to recognize the term “hedge fund” says nothing about the strategy used to manage the fund. The concept of a “hedge” was to go both long and short securities to earn a return regardless of the market’s direction. As the number of hedge funds grew, all sorts of stock and/or bonds were used to manage the funds. Each was unique in what it offered.
So, if you are exploring the market for a hedge fund, you really can’t rely on the name. What are the managers doing with your money? Do you believe their strategy will work? And remember, if it does, the managers will get a cut of the gain.
The other alternative investments are venture capital and private equity. This typically refers to funds that invest in non-public securities. That is bonds and stocks that do not trade on the exchanges.
The common view of venture capital is a fund that provides seed money to start a new venture. But venture capitalist’s approach to investing varies in a host of different ways.
Once again, you have to know the strategy being employed.
If you are looking for the potentially high returns from investing in young companies, I would tell you that it would be incredibly difficult for an individual investor to do this on their own. Investing in young companies is a full-time job, and company managements often only offer stock to investors that can actively help them grow the company.
Investing in start-ups and emerging private companies is also extremely risky. Excess returns from venture investing require the capacity to absorb large losses, to make several investments, to be actively involved, and to be patient.
That’s why it’s almost always better to leave this sort of investing to the professionals.
You also need to be very careful in segregating money for venture capital investing. Often these funds are structured so your investment is a commitment to fund specific amounts when the fund asks for the money. The money, once invested, can be tied up for years.
Any money committed to venture capital should be money that you are not counting on for anything other than very long-term returns.
Alternative investments can be a good way in certain circumstances to diversify the holdings of your entire portfolio. In many cases, public stocks and bonds can provide the same diversification, but there are situations where it makes sense to spread your wings into alternatives.
The good news is that alternative investments are much more widely available today with much lower minimum investments required to participate. Even giant discount brokerage firm, Charles Schwab, is getting in on the action.
In a press release in October 2019, Schwab introduced its Schwab Alternative Investment Marketplace. The program gives Schwab’s independent advisor clients access to third party platform sponsors that offer menus of private funds.
The minimum investment for these funds was set (per the press release) at $100,000. That’s lower than what these funds typically require.
The product menu for Schwab’s Alternative Investment Marketplace comes from a third party - iCapital Network. Schwab customers will be given access to a menu of products that have been approved by iCapital’s research and due diligence team. The company promotes itself on its website as being an expert in identifying quality alternative investment managers across a wide spectrum of alternative investment products including private equity, private credit, real estate, and hedge funds.
According to a June 18, 2020 press release announcing the acquisition of Wells Fargo Global Alternative Investments Division, iCapital Network states that it services $58 billion in client assets across more than 720 funds.
That’s a lot of options for individual investors. Even better, if one looks at the iCapital Network website it should be noted that some funds have minimum investments as low as $25,000.
With so many options and low minimum investments, access to alternative investments has never been greater.
Sometimes these investments make sense. Sometimes they do not. It all depends on each client’s situation.
That’s what makes Nicollet Investment Management unique. We take the time and effort to truly understand your situation, needs, and objectives. In so doing we can better ascertain the types of investments you should hold.
Give me a call if you’d like to discuss this further.