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?
- Where are funds held?
- Can funds be verified?
- Who is the firm’s auditor?
- Who manages the firm’s finances?
- Are the books/financial records open for inspection?
As many Bernie Madoff investors would likely advise, be cautious of any red flags, and don’t be afraid to walk away if you’re not getting the answers you need. Credibility and character are vital. If you have a bad feeling, not just about the answer itself but about how the question was answered, it might not be the right opportunity for you. Do not rush or get hurried in the process. There are many good alternative investments out there, as well as many bad ones. Be aware that, unlike a mutual fund, these investments are often illiquid, meaning that you may have limited to no access to your funds once they are invested. It’s important to understand what percentage of your investment will be locked up for an extended period of time, and make sure you have adequate savings elsewhere to cover you in case of an emergency. In summary, the next time you are at a family reunion and cousin Billy brings up a “can’t miss, you gotta get in on the ground floor” opportunity, let him know you have some key questions you would like to ask (and pay attention to his reaction, as it could be a tell).
As you evaluate any alternative investment options, keep in mind this quote from Will Rodgers, “I’m not so much interested in the return ON my money as I am in the return OF my money.” At Creative Planning, our experienced investment professionals are well versed in a wide range of alternative investment types. Our teams are here to help you build a diversified portfolio to achieve your long-term financial goals. For help evaluating alternative investments, or any other financial matter, please contact us.