7.3 Alternative Investments

Alternative investments include assets beyond traditional stocks, bonds, and cash. They can provide diversification and potentially higher returns, but often come with higher risks, lower liquidity, and greater complexity. Investment advisers must understand these characteristics to make suitable recommendations.

Characteristics of Alternative Investments

All alternative investments share certain traits that distinguish them from traditional assets:

Lower liquidity: Harder to sell quickly; may have lock-up periods

Less transparency: Limited disclosure; harder to value

Higher fees: Often 2% management + 20% performance fees

Less regulation: Many exempt from SEC registration

Low correlation: May move differently than stocks/bonds

Accredited investors: Many limited to wealthy, sophisticated investors

Commodities

Commodities are physical goods that serve as the building blocks of the economy.

Types of Commodities

Precious Metals: Gold, silver, platinum, palladium

Energy: Crude oil, natural gas, heating oil

Agriculture: Corn, wheat, soybeans, coffee, cotton

Industrial Metals: Copper, aluminum, zinc, nickel

Livestock: Cattle, hogs

Investment Methods

Physical ownership: Own actual commodity (bullion, coins); storage costs

Futures contracts: Leverage; require rolling contracts; complex

Commodity ETFs: Liquid; may use futures (contango risk)

Mining/producer stocks: Company risk; may not track commodity directly

Commodity mutual funds: Diversified; professional management

Key Features

- Inflation hedge: Gold and other commodities may rise with inflation

- No income: Commodities don't pay dividends or interest

- High volatility: Prices can swing dramatically

- Storage costs: Physical commodities require safekeeping

- Diversification: Low correlation to stocks and bonds

In Practice: An investment adviser recommends a small gold allocation (5-10%) to a client concerned about inflation. The adviser explains that gold has historically served as a store of value during inflationary periods, though it generates no income and can be volatile in the short term.

Hedge Funds

Hedge funds are privately offered pooled investment vehicles that use sophisticated strategies to seek absolute returns.

Structure and Fees

Legal Structure: Limited partnership

Minimum Investment: $100,000 - $1 million+

Fee Structure: "2 and 20" (2% management + 20% of profits)

Lock-up Period: 1-3 years typically

Redemption: Quarterly or annually; notice required

Regulation: Limited; exempt from Investment Company Act

Common Hedge Fund Strategies

Long/Short Equity: Buy undervalued, short overvalued stocks. Risk Level: Moderate

Global Macro: Trade based on macroeconomic trends. Risk Level: High

Event-Driven: Profit from corporate events (M&A, bankruptcy). Risk Level: Moderate-High

Market Neutral: Equal long and short; minimize market exposure. Risk Level: Lower

Distressed Securities: Invest in bankrupt or troubled companies. Risk Level: High

Managed Futures: Trade commodity and financial futures. Risk Level: High

On the Exam

Key hedge fund points:

- "2 and 20" fee structure (management + performance)

- Accredited or qualified investors only

- Lock-up periods restrict liquidity

- Limited regulation compared to mutual funds

- High-water mark: Manager must recover losses before earning performance fees

Private Equity

Private equity involves investing in private companies or taking public companies private.

Types of Private Equity

Venture Capital: Focus - Early-stage startups. Time Horizon: 7-10 years

Growth Equity: Focus - Expanding companies. Time Horizon: 5-7 years

Buyout (LBO): Focus - Acquiring mature companies. Time Horizon: 4-7 years

Distressed: Focus - Restructuring troubled companies. Time Horizon: 3-5 years

Characteristics

- Illiquid: Capital locked for 5-10+ years

- J-curve: Initial negative returns; profits come later

- Capital calls: Investors commit capital; fund calls as needed

- High minimum: Often $250,000 - $1 million+

- Limited partners: Investors are passive

- General partner: Manager makes investment decisions

Real Assets

Real Estate

Direct ownership: Control; management burden; illiquid

REITs: Listed REITs are liquid and exchange-traded; non-traded REITs are illiquid; 90% distribution requirement

Real estate funds: Diversified; professional management

Crowdfunding platforms: Lower minimums; less liquid

Other Real Assets

- Timberland: Long-term appreciation; income from harvesting

- Farmland: Income from crops; land appreciation

- Infrastructure: Toll roads, airports, utilities; stable cash flows

Collectibles

Collectibles include tangible items valued for their rarity and desirability.

Types

- Art and antiques

- Rare coins and stamps

- Fine wine

- Classic cars

- Sports memorabilia

- Jewelry and watches

Characteristics

Highly illiquid: Difficult to sell quickly

No income: No dividends or interest

Subjective valuation: Value based on opinion

Storage/insurance costs: Ongoing expenses

Special tax treatment: Maximum 28% capital gains rate

On the Exam: Collectibles are taxed at a maximum 28% long-term capital gains rate - higher than the 20% maximum for most other capital assets.

Digital Assets (Cryptocurrencies)

Digital assets have emerged as a new alternative investment category.

Characteristics

High volatility: Extreme price swings common

24/7 trading: Markets never close

Decentralized: No central authority

Regulatory uncertainty: Rules still evolving

Security risks: Hacking, lost keys

No FDIC insurance: Not protected like bank deposits

Suitability Considerations

Digital assets are speculative and suitable only for investors who:

- Understand the technology and risks

- Can afford to lose their entire investment

- Have a high risk tolerance

- Don't need liquidity

Suitability Considerations

Alternative investments are generally suitable for:

- High net worth individuals

- Accredited investors

- Those with long time horizons

- Investors who can tolerate illiquidity

- Those seeking portfolio diversification

Alternative investments are NOT suitable for:

- Investors needing liquidity

- Risk-averse investors

- Those with short time horizons

- Investors who don't understand the investment

- Those who cannot meet accredited investor requirements

Key Takeaways

- Alternative investments include commodities, hedge funds, private equity, real assets, collectibles, and digital assets

- Common characteristics: low liquidity, high fees, limited transparency, low correlation

- Commodities serve as inflation hedges but produce no income

- Hedge funds use "2 and 20" fees; require accredited investors; have lock-up periods

- Private equity has a "J-curve" return pattern with long lock-ups

- Collectibles are taxed at a maximum 28% capital gains rate

- Suitability requires understanding the investor's liquidity needs, time horizon, and risk tolerance