Streetwise for Sunday, November 7, 2021

Several readers have asked about the efficacy of investing in what are called “alternative investments” as part of a diversification strategy.

Alternative investments are part of what is called modern portfolio theory.

Specifically, creating a portfolio of uncorrelated assets and combining those assets in such a way as to generate the greatest return albeit with minimum risk. Risk being defined here as the statistical standard deviation of the portfolio.

Larger portfolios can, under certain circumstances, benefit from alternative investments. These investments under the right conditions and selection criteria could add to the overall return of a portfolio, while at the same time reducing risk. The most common of these investments are hedge and private equity funds.

However, there is no dearth of controversy regarding such alternative investments. Warren Buffett has long been a critic, calling alternative investing, “A fool's game."

One key reason is extremely high fees. The result is billions of dollars for the managers and far less for clients.

In a letter to Berkshire Hathaway shareholders. Buffett wrote that many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers who, in turn, recommend other high- fee managers. In Buffett’s opinion using such a strategy was less than desirable.

Those using alternative investments most often include wealthy individuals, along with mutual funds, pension funds, university endowments, foundations and even sovereign wealth funds managed on behalf of countries.

Given that a discussion of alternative investments most often is referring to hedge funds, let us define in broad terms what is being talked about. Specifically, what are hedge funds and what generates their desirability?

The term "hedge fund" was first applied in the 1940s to alternative investor, Alfred Winslow Jones. He created a fund that sold stocks short as part of his strategy.

Today, hedge funds are privately-owned companies that pool investors' dollars and reinvest them into complex financial instruments in hopes of outperforming the overall market.

That of course is everyone’s goal. However, hedge funds believe they can create high returns despite the vagaries of the markets, not unusual desirability.

More than 8,000 hedge funds managed $2.8 trillion in 2014 (the latest data available), according to HFR Inc., a subscription hedge fund reporting service. That is triple the amount managed in 2004.

Although hedge funds did outperform the stock market for a period that included the financial crisis of 1988, that superior performance ended in 2009.

Among the universe of hedge funds, the super-large funds receive a disproportionate share of investor dollars. Approximately $75 billion was added to funds in 2014, of which 90 percent went to funds that managed $1 billion or more.

The smaller or start-up funds represent a considerably greater risk, with the result that 864 firms closed in 2014, averaging only $70 million each in assets.

Hedge funds are set up as limited partnerships or limited liability corporations that protect the manager and investors from creditors if the fund goes bankrupt. The contract describes how the manager is paid. It may sometimes outline what the manager can invest in, but often there are no limits, and your funds cannot be withdrawn for a period of years.

Some hedge fund managers must meet a hurdle rate before getting paid their portion of the profits. The investors receive all profits until the hurdle rate is reached, then the manager receives a certain percentage.

Most hedge funds operate under the “2 and 20” rule, meaning they earn 2 percent of the assets managed and 20 percent of all profits after exceeding the hurdle rate if there is one.

Hedge funds managers are only at risk for their percentage of their fund’s profits. If the fund is unprofitable, they still receive 2 percent of the assets managed. Therefore, they become very risk tolerant. Investors consequently could potentially see little or no return on their investment with substantial loss possible.

If you plan to investigate hedge funds, please read the SEC Bulletin on Hedge Funds. It offers up a primer on hedge funds, including how to select a hedge fund manager.

Lauren Rudd is a Managing Director with Raymond James & Associates, Inc., member NYSE/SIPC. Contact him at 941-706-3449 or Lauren.Rudd@RaymondJames.com. All opinions are solely those of the author. This material is provided for informational purposes only, is not a recommendation and should not be relied on for investment decisions. Investing involves risk and you may incur a loss regardless of strategy selected. Past performance is no guarantee of future results.