7 Popular (and High Risk) Alternative Investments
Conventional investments like stocks and bonds add liquidity to an investor’s portfolio and allow for seamless regulation by the U.S. Securities and Exchange Commission (SEC). Alternative investments, however, are complex, high-risk securities meant for wealthy, experienced investors who fully understand their potential risks and rewards. In most cases, alternative investments can’t be traded on a public exchange, and are less regulated. Additionally, alternative investments typically don’t offer verifiable performance data, making it difficult to value the products accurately. Despite these issues, the alternative investment market is expanding.
If your broker recommends an alternative investment not suitable for you, you should consider hiring a securities attorney to help you recover your losses.
1. Non-Traded Real Estate Investment Trusts (REITs)
Real estate investment trusts (REITs) own and operate income-producing real estate or real estate-related assets. For example, a REIT might own an apartment complex or real estate-related debt, like mortgages. The SEC requires publicly-traded REITs to register and file regular reports. REITs can trade on a public exchange.
Non-traded REITs present more risk to investors and comply with more relaxed regulatory requirements. As the name suggests, they do not trade on a public exchange. The SEC issued an Investor Bulletin warning investors of the primary risks associated with non-traded REITs, namely lack of liquidity and high fees. The inability to trade makes investments in non-traded REITs very illiquid. Investors must generally wait for the non-traded REIT to list its shares on a public exchange or liquidate its assets. While non-traded REITs can offer redemption opportunities for investors, the redemption could require you to redeem your shares at a discount. As a result, you lose part of your investment. Because of the lack of liquidity, investors who may need to sell assets to raise money quickly may encounter problems with investments in a non-traded REIT.
Additionally, the SEC cautioned investors about the high fees charged by non-traded REITs. The fees can represent up to 15% of the offering price, lowering the potential return on your investment. Non-traded REITs can also charge steep transaction fees. If you have suffered alternative investment losses, contact a securities attorney today.
2. Hedge Funds
Hedge funds act as another form of alternative investment funds. In a hedge fund, the fund pools the money of its investors and invests those funds in an attempt to get a positive return. Depending on the number of assets in the hedge fund, some hedge fund managers can avoid registering and filing public reports with the SEC. Typical investors in hedge funds include pension funds, insurance companies, and wealthy individuals.
Hedge funds typically charge investors an annual asset management fee of 1-2% of the fund’s assets. They also may charge a “performance fee” of 20% of the fund’s profit.
In some cases, investment losses in hedge funds arise as a result of misconduct by the hedge fund manager. For this reason, you should always research the person or people responsible for managing a hedge fund prior to investing. If the research reveals numerous disciplinary proceedings by regulatory agencies and customers’ complaints, you might want to avoid investing with that hedge fund.
3. Private Equity Funds
Private equity funds operate similarly to hedge funds and involve payment of management fees as well as a percentage of the profits. However, private equity funds invest directly in companies by purchasing private firms or buying a controlling interest in publicly traded companies. While hedge funds focus on short-term profits, private equity funds focus on the long-term potential of the companies they currently hold an interest in or plan to acquire. Once the private equity fund acquires a controlling interest in a company, it tries to improve the company through management changes, simplification of operations, or expansion. For a private equity fund, the ultimate goal is selling the company at a profit.
When you invest in a private equity fund, you shouldn’t expect to withdraw your investment for a fairly long period. Investors who want to withdraw their investment would face serious disappointment with a private equity fund.
4. Non-Traded Business Development Companies (BDCs)
Non-traded business development companies provide financing to small and medium-sized start-up businesses that can’t obtain financing through traditional avenues. While this might initially sound appealing, BDCs typically charge higher interest rates than typical financial lenders.
BDCs charge very high initial fees for investors and collect ongoing fees throughout the investment period. Many brokers tell clients returns will outmatch these steep fees. However, returns depend on the success of the BDC. Additionally, BDC investments often lack liquidity and present significant risk. Thus, these alternative investments are unsuitable for the average investor.
5. Special Purpose Acquisition Companies (SPACs)
The SEC recently issued an Investor Bulletin explaining special purpose acquisition companies (SPACs) and their risks. SPACs—also referred to as blank check companies—have gained popularity as a way to transition a private company to a publicly-traded company.
First, the SPAC must complete its own initial public offering (IPO). However, unlike a traditional IPO, the SPAC has limited assets and doesn’t have underlying business operations. If you invest in a SPAC at this stage, you rely on the management team or sponsors that formed the SPAC to find an operating company to acquire or combine with. This is referred to as the “initial business combination.”
Once the SPAC identifies a business it wants to acquire, the management team negotiates with the operating company to execute the business combination. In some SPACs, shareholder approval is required to confirm the business combination.
After the IPO, the SPAC only has two years to identify and complete an initial business combination transaction. If the SPAC fails to do so, the SPAC can liquidate and issue shareholders their pro-rata share of the aggregate amount on deposit.
The SEC has also warned investors against investing in SPACs based on the optimistic predictions of a celebrity sponsor.
6. Non-Traditional Index Funds
A traditional index fund is a portfolio of stocks or bonds designed to mimic the performance of a financial market index. The index fund seeks to match the risk and return of the market, operating on the assumption the market will outperform any individual stock in the long run.
However, some index funds, referred to as non-traditional index funds, use more complex investment strategies. These funds use custom-built indexes to select the fund’s investments rather than a market index. The custom-built index could focus on specific characteristics, numerical methods, or environmental, social, and governance factors to select the fund’s investments.
Many investors experience difficulty understanding the complexities of non-traditional index funds. You want to make sure you thoroughly understand any investment your broker recommends.
7. Insurance-Linked Securities
Insurance-linked securities (ILS) are alternative investments allowing investors to speculate on a variety of events, from weather catastrophes to pandemics. This alternative investment group isn’t typically offered to retail investors. Insurance-linked securities are sometimes referred to as “catastrophe bonds.”
The “sponsor,” usually an insurance company or reinsurance company, may want to transfer some or all the risk it assumes in insuring a catastrophe. The insurance company sets up a special purpose vehicle (SPV) to issue catastrophe bonds. The sponsors invest the funds in low-risk securities, which make up the collateral. The sponsor makes periodic, variable rate interest payments to investors using the earnings made on the low-risk security investments, plus the insurance premiums paid to the sponsor.
Provided the catastrophe covered by the bonds does not occur during the time the investors hold the bond, investors receive their interest payments and their principal back from the collateral once the bond matures. The maturation period for catastrophe bonds usually spans one to five years. If the catastrophe occurs, the sponsor receives the collateral. As a result, the investors lose a majority of their investment.
The potential for investors suffering huge losses in catastrophe bonds causes the bonds to receive a “non-investment grade” rating by credit agencies. These are also referred to as alternative high-yield investment bonds.
The companies offering catastrophe bonds rely heavily on catastrophe risk modeling firms. These firms estimate the probability and potential financial damage of upcoming natural disasters. Ordinary investors most likely do not have access to these risk models, and therefore cannot adequately access the risk that comes with these types of securities.
Contact Kurta Law Today
The SEC and FINRA outline a number of rules financial advisors must follow when recommending investments to customers. If your broker recommended unsuitable alternative investments, you could recover compensation through FINRA arbitration. Contact our office today so we can help you recover the compensation you deserve.