Alternative Investments

April is Financial Literacy Month, a perfect time to answer your questions about the murky world of “Alternative Investments.” These vehicles fall outside of the more commonly utilized individual stocks, bonds, mutual and exchange-traded funds. In general, they are used by large institutions, like pension funds, endowments, foundations and wealthy (“accredited”) individuals.

The Securities and Exchange Commission defines an accredited investor as anyone who earned income that exceeded $200,000 ($300,000 with a spouse) in each of the prior two years, and reasonably expects the same for the current year, OR has a net worth over $1 million, either alone or with a spouse (excluding the value of a primary residence). The SEC’s view is that these investments are risky, so retail investors seeking to put money into one of them better have ample resources and sufficient knowledge.

The cost of alternative investment pools can be steep. In general, there are two levels: two percent of assets under management, plus 20 percent of any upside gains (“two and twenty”). Those high costs often eat into the return. Additionally, alternative investments also carry “liquidity risk,” which means you can’t call the folks running your fund and ask for your money on demand as you are usually locked up for at least a few years.

Here are brief explanations of the alternative investments:

Hedge Funds: Back in the late 1980’s, hedge funds occupied a tiny corner of the investment world. They were meant to provide investors with a means to defray -- or hedge -- some of the risk that they carried in their portfolios with various financial products. Today, hedge funds have become a hodge-podge of different strategies, offering investors a way to differentiate from their more traditional assets.

Often touted as “market-beating,” data from Hedge Fund Research showed that last year, these funds gained just 8.5 percent on average, while the S&P 500 Index was up 19.5 percent.

Private Equity (“PE”): Investors who want to directly invest in other companies, rather than buying stock, form pools called private equity funds. The goal is to increase the value of the company either by growing it, by cutting costs or a combination of both. PE firms usually buy the whole company, using some of their own money as well as borrowed money or “leverage,” which can magnify the return on the upside, or the loss on the downside. While the private-equity fund and its investors own the company, they can receive income, but the bigger pay off occurs when the company is sold.

A recent example of private equity in the news was Toys-R- Us, which filed for bankruptcy last year and never made it out. In 2005, Toys-R- Us sold itself to private equity firms, which financed the deal with a massive amount of debt. In the end, the debt was too much to bear and the whole enterprise went belly up.

Venture Capital (VC): If PE firms often like to buy undervalued, established companies, VCs seek to fund the early stages of young companies that need money to grow. The goal is to help the company become large enough to attract the interest of a larger company that would buy it, or to go public. Either event allows the VCs to cash out.

Angel Investing: If you are confident in your ability to find a great start-up or private company, you can write a check directly and skip the PE or VC -- and their fees. Many small companies raise money through a “private placement,” which is a high-risk venture, predicated on management being able to execute their strategy.