Gary D. Halbert President & CEO

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

With the stock market coming off of a wrenching 3-year bear market and analysts warning of real estate and bond “bubbles,” the most common question I receive from people is where can they invest their money to make a reasonable return with manageable risk.  Many of these investors have turned to so-called “Alternative Investments” in an effort to rebuild their nest eggs.

In this issue of Forecasts & Trends E-Letter, I will begin a multi-part discussion of Alternative Investments.  I will generally define what they are, 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 in Jan-Feb-Mar on the “Mutual Fund Merry Go-Round,” this will be another series of hopefully very educational articles on the Alternative Investment 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).  

Defining What Are “Alternative Investments”?

One of the biggest challenges for this article was coming up with a concise definition of an Alternative Investment.  And to what are these newer investment vehicles an alternative?  Some ultra conservative investors would 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 or structure, 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: 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. 

In addition to these, I would also consider the following as Alternative Investments: hedge funds, managed futures funds, private equity offerings, currency funds, direct participation programs (limited partnerships), and other funds that use derivatives.

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, managed futures funds, private equity and others.  In this issue, however, I will concentrate on things you should generally know about ALL types of Alternative Investments.

A Few Overall Precautions

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 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, with many requiring investments of $1 million or more, and some at $5 million or 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.

As this is written, the SEC and other securities regulators are looking at regulating certain types of Alternative Investments 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.

4. Many Alternative Investments have fees that are much higher than those related to stocks, bonds and mutual funds.  It is not uncommon for a hedge fund or other alternatives to charge a 1-2% annual management fee, plus 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 net of all fees and expenses, you will generally have to review the fine print disclosures accompanying the 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 asset strategies can produce higher net returns than comparable low-fee alternatives.

5.  As mentioned above, some Alternative Investments that are private offerings are regulated more loosely than traditional securities.  However, there are some Alternative Investments that are not regulated at all by the SEC or NASD.  This class of Alternative Investments includes, among others, “viatical settlements” and “senior life settlements,” which both involve buying existing life insurance policies on sick or older persons at a discount and waiting until they die.  (Sounds pretty morbid, doesn’t it?)

The subject of viatical and senior life settlements is large enough for an entire E-Letter on its own.  While some states have attempted to regulate these types of products through their insurance departments, these types of investments are still mostly considered private property transactions, with limited regulatory oversight in many cases.  Therefore, the term “caveat emptor” (buyer beware) gains even greater significance.

6.  Many Alternative Investments are very illiquid.  Many hedge funds and other alternative investment funds have very restrictive policies for getting your money out.  Some only allow redemptions once a year, or twice a year or quarterly.  There is no market for these securities, so you must understand the illiquidity issues going in and consider such investments only for the long-term.

7.  Generally speaking, no single type of Alternative Investment should amount to more than 10 to 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 your whole life savings into these investments.  Resist that advice!

8.  Even though some Alternative Investments, especially some hedge funds, can show a history of positive returns with very low 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.

9.  Finally, the standard rule of investing still applies:  If it sounds too good to be true, it probably is.

Adversity Breeds Marketing

With interest rates at the lowest level in over 40 years, and the stock market gaining but still very risky, Alternative Investments are growing in popularity among sophisticated investors.  As noted above, many of these investments are only available through private offerings.  As such, they are not allowed to advertise these investments.

Unfortunately, there are unscrupulous investment sponsors who are very actively promoting bogus investments in an effort to attract investors who are scared of the stock market but frustrated with low interest earnings.  Others may promote legitimate investments, but might overstate the potential benefits or understate the risks of the alternative strategies.

Most vulnerable are those investors who are retired and trying to live off of the income generated by their investments.  With interest on CDs and other fixed-rate investments so low, seniors are looking into alternatives to maintain their standard of living.  In addition to this group are investors who lost huge amounts of money in the stock market when the tech bubble burst.  Many of these investors are looking for a way to make up for all of their losses.  Investment scam artists consider groups of investors like this to be “ripe for the picking.” 

In my January 21, 2003 E-Letter , I discussed the increase in investment scams and how to avoid them.  You can view that issue by CLICKING HERE.  In addition to what I said in January, I would like to provide the following list of telltale signs of investment fraud from the SEC:

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 to 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.

Balancing Opportunity And Risk

From reading the cautions in this article, you may think that I am against the use of Alternative Investments.  Nothing could be further from the truth.  My company has sponsored a number of Alternative Investments over the years.  However, as with any investment, Alternative Investments must be consistent with an investor’s 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.  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 Internet e-mail or chatroom.

My firm, ProFutures Investments, is active in helping investors determine whether various investments are suitable for them.  You can call 1-800-348-3601 and talk to any of my Investor Representatives and they can help you out.  If you insist on someone closer to your local area, you can find a qualified Financial Planner by going to the Financial Planning Association website ( www.fpanet.org) and clicking on “Find A Planner.”

Conclusion

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.

Most 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. 

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