The Importance of Conducting Due Diligence Before Investing in Alternatives
Many of us have a friend, family member, neighbor or old classmate who’s always reaching out with a “can’t lose, you’ve got to get in on the ground floor” investment opportunity. These are often alternative investments that range from a new business venture to a real estate opportunity to a type of loan, just to name a few. Of course, there is nothing inherently wrong with listening to a proposed opportunity. However, it’s important to separate your relationship with the person proposing the investment from the investment itself. Before you decide to invest in your former classmate’s “sure thing” opportunity, consider the following.
What is an alternative investment?
It may be easier to clarify what an alternative investment is not. An alternative investment is not a traditional investment, which includes stocks, bonds, cash and some types of liquid real estate funds. Mutual funds and exchange-traded funds are also considered traditional investments because they hold stocks, bonds, cash, etc. Everything else is considered an alternative. Examples include, private equity, hedge funds, wine, gold, artwork, coins, business ventures and more. The list goes on and on.
Why would you want to consider investing in something other than traditional investments?
The main reason you may consider investing in alternatives is to diversify your portfolio. Alternatives have the potential to perform well even when the S&P 500 Index is struggling, and they may also perform well when the S&P 500 Index is doing well. Having different types of investments can provide diversification in your portfolio, which can lessen its downside risk. The strength of the relationship between an alternative investment and the market index is expressed in terms of correlation. Correlation can range from 1 (a perfect positive correlation) to -1 (a perfect negative correlation). An investment with a perfect positive correlation to another investment moves in lockstep. So, if investment A increases by 10 percent, investment B also increases by 10 percent. On the other hand, if two investments have a correlation of -1 (negatively correlated), investment A may increase by 10 percent while investment B decreases by 10 percent (or vice versa). Investments with 0 correlation move completely independently of one another. For example, investment A is up 10 percent and investment B is up 5 percent in one scenario and in another scenario, the same investment A is down 5 percent while the same investment B is up 4 percent. This is ideal but hard to find.
How should I research?
It’s critically important to conduct proper due diligence on any investment you may consider adding to your portfolio. Begin by gaining clarity around the following:
What is my potential rate of return?
How long will my assets be tied up?
What options do I have to get my money back?
How do I know the ongoing value of my investment?
These questions serve only as a starting point because each investment type has its own specific risks. For example, real estate is heavily influenced by geography risks.
The most important questions have to do with the investment manager (manager selection), and may include:
How many similar investments has the investment group done in the past?
What is the background of the investment managers and key firm personnel?
What kind of returns has the manager been able to achieve with past investments?
How have the firm’s investments performed during good economic times? How have they performed in bad economic times?