Broadly defined, alternative investmentsare pretty much any investment outsideof the traditional categories or investmentstrategies involving stocks, bonds,most mutual funds, and cash equivalentslike CDs. Alternative investments tend tobe riskier than traditional investments orinvestment vehicles, so before investing inthem you should understand them, andmake sure they are appropriate for yoursituation. Their key benefit is diversification,many Certified Financial Plannerâ„¢practitioners say. The patterns of returns inthese investment categories typically don'tcorrelate with those of stocks and bonds,and hence their presence in a portfolio candampen volatility while potentiallyimproving overall return.
In recent years many investors concentratedon large cap stocks and lost money,because they had no alternatives in theirportfolio when the large caps stumbled.Traditional alternatives might have includedsmall cap stocks, real estate investmenttrusts (REITs), junk bonds, municipalbonds, and international equities andbonds. For those investors for whom lesstraditional alternatives may be appropriate,the benefits of investing in them haveprobably never been more apparent. Thefollowing are a few of the possibilities:
• Hedge funds. Not widely understoodby many investors and sometimeslacking traditional investment disclosures,most of these funds are designed to protector enhance market gains through theuse of derivatives, buying long and short,financial futures, and other techniques.Once-high minimums have dropped to aslow as $25,000 to $50,000.
• Managed futures funds. Thesefunds invest primarily in financial futuresor commodity indexes and thus are riskierthan more traditional investments.
• Commodities. These include futuresand options in everything from porkand wheat to gold and catastrophic insurance.They usually are highly leveragedand face challenging market, weather,or disease factors. For most physician-investors,commodity mutual funds providethe best avenue for such investing.
• Direct real estate. The argumentfor owning an office or apartment building,raw land, rental property, or similarinvestment in real estate rather thanthrough REITs or REIT mutual funds is thatindividual ownership performs differentlyand can provide ongoing tax benefits.
• Limited partnerships. The sameprinciple applies to limited partnerships asowning direct real estate: Limited partnershipshares in an oil and gas well in Texas,for example, behave differently than publiclytraded shares in Exxon.
• Private-equity funds. Private equityinvolves buying into privately held companies,either through funds, which areessentially limited partnerships, or fundsof funds. The 3 main versions of this assetclass are buyout funds, venture capitalfunds, and mezzanine financing.
• Venture capital or angel investing.An alternative to private-equityfunds is to invest directly in local start-upcompanies or small growth companies.As with so many alternative investments,the investment can be exhilarating andrewarding, but decidedly risky.
Although these and other similaralternative investments can provide benefits,they are not without their risks andare definitely not appropriate for manyphysician-investors.
To begin with, fees typically are higherthan traditional investments' fees becauseof the smaller economies of scale andactive management. Investors often mustmeet minimum income and net worthstandards to qualify as investors. Findingappropriate benchmarks can be difficultâ€”it's misleading to compare returns of alternativeinvestments with traditional stockbenchmarks. Investment minimums aretypically much higher and the assets usuallyare more illiquidâ€”commitments of 3 to5 years or more are not uncommon.
What percentage of your portfolioshould you commit to alternative investments?Many planners would say no morethan 10% to 15%, but you should consultwith your financial advisor to determinewhat, if any, percentage is appropriatebased on your own financial situation.
This column is produced by the FinancialPlanning Association (www.fpanet.org), themembership organization for the financialplanning community.