Alternative Investments Know the Risks

3rd March, 2021

Investing in alternatives definitely has its advantages: You get access to some incredibly savvy money managers that can help diversify your portfolio and enhance your returns.

That said, there are risks you need to be aware of before deciding to allocate capital to this asset class. Some of these potential downsides are universal to investing in general, but some are unique to the way alternatives work.

Liquidity is a key risk with alternative investments. Unlike large-cap equities, for instance, there is no liquid, constantly traded secondary market for many alternatives. So, while a stock held through an online broker can usually be liquidated whenever you choose, the same is not true for units of a hedge fund or private equity fund. In those situations, it’s customary for the fund manager to allow redemptions only quarterly.

Private funds also may have the discretion to “put the gates up” (that is, temporarily suspend the ability to redeem) if they believe redemptions might cause undue harm to their portfolio. The clear risk for the investor in this kind of scenario is that they need funds but cannot access them due to the manager’s decision. Liquidity risk can also present itself in the form of what are known as lock-up periods. Private equity funds, for example, can require that investors commit their capital for a minimum of 5 years.

Valuation risk is another potential downside that investors need to be cognizant of. With public equities, determining a mutual fund or ETF’s Net Asset Value is a fairly straightforward process, because they tend to own liquid securities with visible bid-ask prices. Some alternative investment vehicles (such as Long/Short hedge funds), operate in much the same way. But others own assets that may be difficult to value, and for which there is no liquid secondary market that a manager can look to for guidance.

This risk is especially inherent in private equity or venture capital investments. While third party valuation services are often consulted, it is ultimately up to the fund manager to report on what they believe the investments are worth. This presents a potential conflict of interest, because investors may not be receiving a truly independent evaluation of the fund’s assets, and there are obvious incentives for a manager to be biased in favor of a higher NAV.

Leverage is definitely a risk that anyone pondering investing in alternatives should understand. In various ways, hedge funds and private equity funds may lever up their holdings in search of higher returns. If they are successful, this approach can amplify the returns they deliver to investors. On the flip side, however, a leveraged portfolio can result in magnified losses for a fund.

In the last couple decades, some notable hedge funds have found themselves in turmoil after leveraged bets went awry. These include:

  • Long-Term Capital Management, which ultimately required a bailout organized by the Federal Reserve Bank of New York in 1998 after losses on interest rate swaps, equity volatility bets, and other trades
  • Amaranth, a hedge fund that lost billions in the natural gas market
  • The Bear Stearns High-Grade Enhanced Leverage Structured Credit Fund, which made ill-timed investments in subprime mortgages

Market risk is another factor that investors should consider. This risk can present itself anytime a fund is exposed to a particular business line, currency, commodity, or other kind of market. At some level, market risk is unavoidable: It can rear its head due to cyclicality in a sector or even a downturn in the broader economy.

Counterparty risk may not be an obvious danger but it’s certainly worth knowing about. It’s essentially the chance that another business cannot fulfill the terms of contract that is material to a particular company. Think of a hedge fund that purchased over-the-counter equity put options from Lehman Brothers in the summer of 2008. The bet was correct (the market did collapse), but because Lehman went under, the fund probably wouldn’t have been able to profit.

High fees are another factor any investor in alternatives should be aware of. As we’ve written about previously, the classic fee model in hedge funds and private equity funds is “2 and 20”: 2% of the assets under management, plus a 20% performance fee, subject to a so-called high-water mark. This structure has evolved in recent years, with the management fee declining somewhat, and the performance fee increasing. Yet even the newer structure is more expensive for investors than many public market funds (such as ETFs).

Past performance is no guarantee of future results: You may have heard this saying in relation to mutual funds, but it applies to alternatives, too. With fund managers, the risk is that they cannot replicate their enviable track record going forward. Investors are biased to extrapolate the past into the future, but there really is no guarantee that yesterday’s hot hand will be tomorrow’s star manager.

Short positions are a final risk that investors in alternatives should be familiar with. As recent events have shown all too well, short-selling occasionally backfires spectacularly. Whereas the worst thing that can happen if you’re long a stock is that is goes to 0, when you’re short, the risk is theoretically infinite. From time to time, hedge funds have been on the wrong end of vicious short squeezes (think the Volkswagen or GameStop episodes) that have left them (and their investors) nursing severe losses.

View Risks Through a Personal Lens

All investments carry some risk. So how do you decide whether a prospective alternative asset or fund is too risky?

One sensible approach is to weigh the potential risks with what you judge to be the possible upside. A fund or asset with significant downside risk but quite limited room for growth is the kind of opportunity you likely want to pass on. On the flip side, it may make sense to take on slightly more risk than you would in public equities if you judge that the odds for exceptional returns are high.

Of course, it’s also important to connect the possible risks of an alternative investment to your own personal financial situation. Two investors may look at a particular venture and make a similar conclusion on the relative risk vs. reward balance. Yet if one of the investors is more conservative, the investment in question could be riskier for them than it would be for the other person. For example, someone who might need access to their money on short notice may pass on a fund with lengthy lock-up, even if the fund they are looking at isn’t particularly volatile.

Long story short? What is risky for one investor may not be risky for another—there is a personal element at play, and that’s worth remembering. 

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