Alternative investments, particularly complex products, are called that for a reason. The growing popularity of these investments is understandable, given the hype surrounding them lately. The shiny new ideas often get a lot of attention, but that doesn’t mean that they are appropriate for everyone. I became extremely concerned when I recently heard an investor state that they wanted to move completely away from traditional investments and put all of their money into alternative investments. This is a terrible idea for anyone to do, and this week I wanted to focus on why.
First, what is a complex product? Essentially, it is an investment that includes valuations, cash flows, performance or risks that are not easily understood by the average investor. For this reason, they are more scrutinized by regulators and, in most cases, restricted by the type of investor you are and/or limited in the amount of liquid net assets you can invest. In New Jersey, investments into alternative investments are limited to 30% of your liquid net worth.
Complex products include structured products like equity-linked notes, principal-protected notes, reverse convertibles, options, futures, swaps, leveraged ETFs, hedge funds, private equity, private credit, REITs, BDCs, mortgage-backed securities, collateral debt obligations, crypto ETFs, tokenized funds, and, to a lesser extent, even some annuity products.
These products can derive their performance from what we call nonlinear returns. Their performance may rely on derivative mechanics such as floors, caps, or triggers. They may have valuations that are derived from a model or issuer-specific pricing with little to no secondary market value. Secondary market pricing, when available, can vary 10-30% from NAV pricing.
Risks to complex products include:
1. Liquidity risk: Many complex products have limited liquidity, and that liquidity can come at a steep cost if it is offered.
2. Leverage: These products can also use synthetic leverage by employing derivatives or swaps, both of which could potentially increase downside risks.
3. Issuer or counterparty risk: This is the risk that the issuer becomes insolvent. Think Lehman Brothers in 2009.
4. Valuation: Many of these products rely on illiquid assets or Mark-to-Model accounting, which can make valuation difficult to truly understand.
5. Cost: Many complex products are more expensive than traditional investments, and those costs are not always transparent. 3-4%-plus fees are not uncommon in these products.
I don’t mean to convey that all of these products are bad; they aren’t. Sometimes, the only way to access certain investments is via alternative investments. Just realize all of the potential risks involved. If you don’t, then ask more questions. You should always understand two things about every investment you make: what did I buy, and why is it right for me? Just because you hear about something at cocktail parties doesn’t mean it is right for you. Many of these products are limited to investors of a certain net worth. Unfortunately, having a higher liquid net worth rarely translates into being a more sophisticated investor. Understanding what you are buying and why it is right for you is one of the best ways to begin to make good investment decisions.
Securities offered through Kestra Investment Services, LLC (Kestra IS), member FINRA/SIPC. Investment advisory services offered through Kestra Advisory Services, LLC (Kestra AS), an affiliate of Kestra IS. Reich Asset Management, LLC is not affiliated with Kestra IS or Kestra AS. The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Investment Services, LLC or Kestra Advisory Services, LLC. This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation. To view form CRS visit https://bit.ly/KF-Disclosures.
Eric is President and founder of Reich Asset Management, LLC. He relies on his 25 years of experience to help clients have an enjoyable retirement. He is a Certified Financial Planner™ and Certified Investment Management AnalystSM (CIMA®) and has earned his Chartered Life Underwriter® (CLU®) and Chartered Financial Consultant® (ChFC®) designations.
