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ALTERNATIVES TO TRADITIONAL INVESTMENTS
Investors sometimes get bored with traditional investments,
such as U.S. stocks, investment-grade bonds, and the mutual
funds that are invested in those asset classes. Especially when
such investments fail to generate adequate returns as they did
in 2005. And when that happens, investors often tend to hunt for
what some refer to as "alternative" investments,
investments with exotic names that hold out the promise of
higher returns.
Alternative investments are, in simple terms, nothing more
than investments that offer investors the chance to diversify
their portfolio with instruments that may reduce overall risk of
the portfolio and potentially improve returns. Typical
alternative investments include hedge funds, commodities
(futures and options), direct ownership of real estate, REITS
(public and private), limited partnerships, private-equity
funds, venture capital or angel investing, mutual funds
(absolute return funds, long-short funds, and covered writing
funds) and managed futures.
Besides the potential for higher returns and lower portfolio
risk, alternative investments also have these general
characteristics: higher fees, higher investment minimums,
minimum net worth and income requirements for investors, and
illiquidity (3 to 5 year commitments are not uncommon). In
addition, investors may find it difficult to find appropriate
benchmarks against which to measure performance and risk,
unlike, for example, using the Dow Jones Industrial Average or
the S&P 500 to measure the performance of stocks.
As with all investments, alternative or not, it would be
useful to remember what the Romans used to say: "caveat
emptor" — or "let the buyer beware" — when
researching such investments.
So, if you are considering adding alternative investments to
your portfolio be sure to get a sense of your current assets'
combined potential for return and risk and consider whether it
would be realistic to make changes that could significantly
enhance your potential return without an excessive increase in
your potential risk. Often, a major benefit of adding
alternative investments is that it tends to reduce the overall
risk of a portfolio because the value of such investments
doesn't always follow that of stocks and bonds. In other words,
traditional investments and alternative investments are not
"correlated."
Here's a closer look at some of the more common alternative
investments out there:
Hedge Funds. Hedge funds are nothing more than
investment partnerships and, as such, are often precursors of
mutual funds. Some do nothing more than allow the investor to
share the results of the expertise, experience and talents of a
respected manager. Others may pursue very conservative
strategies focused on principal protection. The key thing to
recognize, according to financial planners, is the focus on
absolute returns as opposed to relative returns and
benchmarking. That said, it's important to note that hedge funds
may resemble mutual funds but are far from identical. For
instance:
- The costs of owning them are a
lot higher because they not only charge annual management
fees (around 1-2 percent), they also commonly charge
performance fees of 20 percent of the funds' profits.
- They may use speculative
techniques, such as borrowing money to supplement investors'
money and investing in illiquid securities that can make
them more risky.
- Neither the funds nor most
hedge fund managers are required to register with the SEC.
- Because of their higher level
of risk and little or no SEC oversight, hedge funds tend to
be made available only to the wealthy — those who have net
worth of at least $1 million.
- They may only accept
redemption requests quarterly, as opposed to daily, and may
impose "lockup" periods of a year or more during
which no shares may be redeemed.
Futures and Options. Futures contracts commit you to
buying or selling something for delivery in the future at a
certain price while options contracts give you the right — but not
the obligation — to do so.
Once primarily used for agricultural commodities, futures
contracts now are also available in a growing variety of markets
from metals and fuels to financial instruments including foreign
currencies, U.S. and foreign government securities, and U.S. and
foreign stock indices.
Prices can be highly volatile to reflect ever-changing
balances between supply of and demand for the underlying assets.
Precious Metals. The volatility of the price of gold,
for example, the most widely watched metal worldwide,
illustrates why it is, at best, a speculative asset when not
purchased for actual use. Now trading near $600 an ounce, it
remains far below its all-time high of around $1,000 about 25
years ago — but more than double its most recent lows around $250
at the end of the 1990s.
Anyone who bought gold 25 years ago as a long-term investment
and held it would have lost a lot of money if he or she sold
today — not to mention the missed opportunities for capital gains
in securities. The lesson to be learned is that alternative
investments are available for those who want to diversify their
portfolios, however, they should be fully understood before you
invest in them.
April 2006 — This column is produced by the Financial
Planning Association, the membership organization for the
financial planning community, and is provided by Don McCarty of
Financial Decision Partners, a local member of the FPA.
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