Wealth Matters: On ‘alternative investments,' be aware of risks

'If it sounds too good to be true, it probably is.' Though you've probably heard that many times, it's still a good reminder when considering alternative investments.

Caution is always advisable when investing, yet when it comes to these 'opportunities', extra due diligence is needed. Here's why: these loosely regulated investments can be risky, lack transparency, and have high investment minimums and fee structures compared to traditional mutual funds and exchange-traded funds (ETFs).

An alternative investment is any investment not usually part of a conventional portfolio of stocks, bonds, and cash.

Access to these investments is typically through hedge funds and other partnership vehicles managed by a private investment manager. These managers can tap into otherwise inaccessible markets such as private equity, private debt, private real estate, timber, and oil, gas, or mineral partnerships.

There are many different types of alternative investments and strategies. Let's explore some of the most common: Real Assets, Hedge Funds, Private Equity, and REITs.

Real Assets – Real assets include tangible assets such as art, wine, antiques, coins, or stamps. Individuals who invest in these types of collectibles usually have a great deal of knowledge about their area of interest.

Other real assets can have significant barriers to entry. These investments typically fall into four broad categories: commercial real estate; timber and farmland; oil, gas, and mineral partnerships; and infrastructure. For these investments, investors typically invest in partnerships or private placements.

Hedge Funds/Liquid Alternatives – Private hedge funds and liquid alternatives are most commonly used to pursue complex, nontraditional investment strategies. Private hedge funds typically charge high fees (e.g. 2 percent of assets and 20 percent of profits), enjoy minimal government regulation (remember Bernard Madoff), disclose little information about the fund's investments strategies, and often have 'lock-up' provisions that can severely limit liquidity. On the other hand, liquid alternatives are subject to regulations covering liquidity, diversification, and leverage. However, investors should remain very mindful of high expenses – whether in the form of expense ratios, sales loads, or tax inefficiencies – that directly detract from performance, lack of transparency, and short track records.

Private Equity – Private equity is capital invested in companies or securities that typically are not listed on a public stock exchange. Capital raised by a partnership is used to develop new businesses, restructure or acquire existing businesses, or offer additional funding for established businesses.

There is a widespread perception that successful private equity investments usually provide both exceptional returns and portfolio diversification. But private equity's unique risks include a long (and unknowable) investment horizon, liquidity constraints, and high bankruptcy rate.

Real Estate Investment Trust (REIT) – A Real Estate Investment Trust or REIT is a tax designation for a corporation investing in real estate that reduces or eliminates corporate income taxes. In return for this favorable tax treatment, REITs are required to distribute 90% of taxable income to investors, making it an attractive investment for investors seeking high cash flows.

Like other corporations, REITs can be publicly or privately held. Private REITs carry much of the same risks as private equity. On the other hand, publicly-traded REITs traded on a stock exchange can offer a highly liquid method of investing in real estate and provide significant diversification benefits in a traditional portfolio of stocks and bonds.

Often, alternative investments are associated with short-term speculation, over-concentration, opaque strategies, and excessive costs, leading to corruption of the basic risk/return principles of sound investing. Stocks and bonds are the core investments in a globally diversified portfolio for the long term. Over time, diversified strategies, coupled with disciplined trading and tax management programs have proven quite successful in increasing portfolio returns without taking the unnecessary risks of unregulated investments.

Mark Keating, CFP, AEP, is a Certified Financial Planner and an Accredited Estate Planner with Willow Creek Financial Services, Sebastopol, one of the leading wealth management firms in California. For information go to www.wcfsinc.com or call 707-829-1146. Wealth Matters is a monthly column from the firm's partners.

Originally published Dec. 15, 2014.