A world beyond stocks and bonds

What are investors to do?

More are exploring the parallel universe of alternative investments—commodities, real estate, hedge funds, and the like—in search of higher returns, lower risk, or both.

I’m going to focus here on private investments, which are typically available to “qualified purchasers” (including individuals with $5 million in investments net of debt) or, to a lesser extent, “accredited investors” ($1 million net worth, excluding the home). The criteria are complex, but you get the picture. These are the people deemed by the Securities and Exchange Commission to be able to assume the risks and fend for themselves in the less liquid, less transparent world of unregistered securities. (Increasingly, alternatives are also bought through mutual funds that seek to emulate private strategies while complying with the rules on liquidity and leverage. I plan to address “liquid alts,” as they’re called, in a future column.)

Why alternatives? One reason is their potential to diversify a portfolio, and in so doing improve the risk/return ratio. Second, they increase opportunities, not just by widening the playing field but also by incorporating the less-well-lit corners where you might take advantage of pricing inefficiencies. Now, they also widen the field of risks—lack of liquidity being central to private investments—and you need to be compensated for taking those additional risks.

How much more return should you require in the private markets? While there is no set number, a 50 percent premium might not be a bad place to start. In other words, if you’d expect to earn 10 percent in the public markets, you’d want 15 percent or more on a private deal.

Oil and gas are interesting now, not least because of the new drilling technology (love it or not). Long-short funds provide a means of hedging against a stock-market correction without ­adding to bonds or cash. (A long-short manager bets part of the fund’s money on the market going up and part on it going down, reducing overall risk and attempting to add value by picking individual winners and losers.)

But favorable markets come and go. What shouldn’t change is the due diligence process—with whom are you investing, and what is the structure? With private investments, here are some questions to keep in mind:

• Do you know enough about the person or company you’re hiring to steer the boat? Don’t confuse familiarity with knowledge. The person you’ve known for years through the country club or your church requires the same scrutiny as a stranger.
• Are your interests aligned with the sponsor’s? Does the sponsor make or lose money when you do or does he profit from up-front commissions or hefty yearly management fees? In the best case, you as a limited partner will get payments ahead of the general partner. Is the sponsor investing his or her own money? What is the fee structure? (Attention to fees applies with mutual funds as well.)
• Is there a track record? Years ago my boss received a call from a manager whose private fund was just getting off the ground. My boss told him to call back if he was still in business in five years. Fast forward, the phone rang again. “Lew,” said the voice on the other end, “the five years is up.” Thus began a business relationship.
• What can go wrong? Always ask yourself, “How can I lose my money?”
• Do you understand it? If not, don’t invest in it.
• How much of the return is powered by debt? For perspective, figure out what you’d expect to earn on a traditional public investment with the same amount of leverage.
• Does it pass the smell test? If you think returns are too high to be real, be skeptical and get more facts.

If you get the right answers to questions like these, private alternative investments can offer you attractive opportunities. 

Paul Palazzo, a Certified Financial Planner, is the managing director at New York-based Altfest Personal Wealth Management.