Most people understand traditional investments like stocks and bonds, money markets, and mutual funds. There are also a number of alternative asset class investments which can enhance a portfolio, but many physicians have lingering concerns about them.
Many people still remember horror stories from the 70’s and 80’s about limited partnerships that went bad and cost physicians their life savings. Abandoned real estate developments. Dry oil wells. Non-producing gold mines. Some physicians are concerned that today’s alternative investments are, like those old ones, too risky for prudent investors. The truth is that some are, and some are not.
Unlike traditional asset classes, which are highly structured and regulated, alternative investments can vary from independently packaged and negotiated transactions to institutional private offerings. Alternative asset classes can include real estate, private loans and mortgages, oil and gas, venture capital and private equity, market neutral and others focused on timber, metals, water, etc. The private offerings within the alternative asset classes range from mobile home communities in Florida, to oil drilling leases in Texas, to office buildings in New Jersey, to futures in cocoa and Euros dollars. They are as diverse as they are numerous.
A lot has happened since the 70’s and 80’s to change the alternative investing dynamic. Stricter regulation and better due diligence now make some of these alternative investments safer, less costly, less risky, more profitable, and therefore, more desirable. When combined with traditional investments, alternative asset classes can enhance portfolio diversification, and reduce overall risk.
Choosing the right investments
One of the keys to reducing risk when designing an investment portfolio is to select a variety of asset classes that are not correlated to one another. In other words, you don’t want everything in a portfolio to move in the same direction and at the same time as the stock and bond markets. The best way for physicians to reduce overall portfolio risk is to have an efficient mix of asset classes. That way, when some asset classes go down, others go up. That’s called negative correlation, and it’s definitely a good thing!
The problem with traditional asset classes is that they are usually highly positively correlated with
one another. Including alternative asset classes along with traditional asset classes in an investment portfolio can provide more effective diversification and lowers overall portfolio risk.
The Bad News
Alternative investments have regulatory (SEC) restrictions. Typically, investors cannot participate in these private offerings unless they are accredited (have at least $1,000,000 of investable assets, or $200,000 per year income). In the case of futures and commodities, investors need to be qualified eligible participants (have at least $2,000,000 in assets). Here are some other negatives about alternative asset classes:
● There are usually no mutual funds or exchange traded funds in these asset classes.
● The minimum investment size is usually higher.
● Investment expenses are usually higher.
● They are usually illiquid.
● Disclosure is not standardized, like a prospectus for a mutual fund.
● Tax information is distributed differently, usually on a schedule K-1, and usually after April 15th .
● Conflicts of interest can be a problem.
● Management controls are not standardized, making fraud an issue.
● Some products are structured so that the SEC has jurisdiction; others are regulated by the CFTC; some
are organized offshore for tax/legal reasons.
● There is a wide variety in motivational structures which can have a huge impact on the projected and
actual economic performance.
The Good News
The major advantages of alternative asset classes over traditional asset classes are:
● They can result in a lower portfolio risk.
● They can offer a strong overall return.
● They can offer greater control of costs, since the terms are sometimes open to negotiation.
● They can offer improved portfolio diversification.
● They often incur lower taxes.
● They can be different, unique, and exciting.
Since most alternative asset classes are not available to individual investors, physicians interested in including them in their portfolios should speak directly to their investment advisor. To reiterate, to be able to differentiate between a good and bad alternative investments requires extensive due diligence. Properly screened, the good ones can increase portfolio diversification and lower risk.
See our next article in this 6-part series: Sorting though the alphabet soup of investment advisor professional credentials.