WHATÂ´S FOR DINNER?
This is one of the worldâ€™s most common questions. For most of history, the answer has been whatever one caught, found growing, or cultivated. Today we have more choices than ever, and we make our selections based on a variety of factors, such as health, taste and price. But do we know how to choose and prepare unfamiliar foods? It is a similar situation for investors, brokers, managers and brokerage firm owners, who, faced with a smorgasbord of alternative investment options, are asking, â€œWhat investments are available? Do I understand them? What should I let my reps sell? What should I show to my clients?â€ Stocks and bonds may be the meat and potatoes of the investment industry, but it can be very unhealthy to rely on them for every meal.
You say tomato
What is an alternative investment anyway? If you read 10 books on the subject you will encounter 10 different sets of criteria. If it is hard to agree on what an alternative investment is, perhaps we can begin by agreeing on what it is not. It is not a stock. Buying 100 shares of IBM certainly lacks the mystique and danger generally associated with alternative investments. So you can rule out bonds as well, since the only thing less dangerous and mystical than buying 100 shares of IBM would be purchasing a AAA-rated bond from big blue. Nothing new here, but as we list different investment themes a few items are generally accepted as alternative investments.
SIX OF ONE, HALF DOZEN OF THE OTHER
You can divide alternative investments into two groups: land and non-land. Some alternative investments incorporate both types. The main difference between the two is liquidity and protection. In stable Westernized countries, land law is very powerful. Concerns about municipal governments using eminent domain to forcibly purchase land from unwilling owners has been a very controversial topic. In general, land ownership is protected by the government. In fact, certain types of land (i.e., farmland, oil and gas exploratory areas) are either directly or indirectly subsidized by the government. Investments in REITs, farmland, timberland, oil and gas, and tax liens are all direct land investments. Managed futures, private equity, ETFs and, for the most part, hedge funds are non-land investment vehicles. They are usually much more liquid than their land-investment counterparts. They also tend to offer the sexier types of investments, such as media and entertainment, high tech, bio tech, etc.
Private Equity â€“ Includes investments that are in non-publicly traded entities. Originally large family wealth like the Rockefellers or Fords would invest money in relatively smaller fast-growing businesses. Today, private equity groups are funded by a diverse collection of organizations in the public and private sectors as well as by individuals. They now invest the majority of their money on buyouts of large established firms.
Companies such as Kohlberg Kravis Roberts & Co. (KKR) made private-equity firms infamous for hostile takeovers during the 1980s. At the time, KKR was the worldâ€™s biggest fund with approximately $150 million. Todayâ€™s largest fund is J.P. Morgan Partners Global 2001 Fund with over $6.5 billion. There are now plenty of private-equity firms with over $1 billion. The range in returns, like other investment vehicles, varies greatly from best to worst funds.
Private Placements â€“ A private placement offering (PPO) refers to any type of offering of securities to any number of private accredited investors. Securities offered through a private placement are exempt from registration with the SEC, provided that the appropriate offering documentation â€” usually referred to as the private placement memorandum or PPM â€” is prepared in compliance with federal and state regulations.
Managed Futures â€“ A managed futures account is like a mutual fund, except that the positions are generally in government securities, futures contracts, and options on futures contracts. Different risk strategies are used to manage the portfolio.
ETFs â€“ Exchange traded funds are not considered alternative investments by the general population of the financial world. We talk about them here to highlight the point that the more regulated an investment is, the less likely it will be considered alternative. If you were to go by the definition that an alternative investment is one that is neither a stock nor a bond, ETFs would fit the bill. Being able to short ETFs certainly gives them that unique risk/reward potential that has an alternative-investment feel. In fact, the recent popularity of ETFs is somewhat of a testimony to the uniqueness of that type of investment vehicle. It is sometimes the uniqueness often mistaken for mystique that makes an alternative investment attractive to a potential investor.
An ETF is a security that tracks indices and represents baskets of stocks like an index fund, but trades like a stock on an exchange, thus experiencing price changes throughout the day as it is bought and sold. Because it trades like a stock whose price fluctuates daily, an ETF does not have its net asset value (NAV) calculated every day like a mutual fund. With an ETF, you get the diversification of an index fund as well as the ability to sell short, buy on margin, and purchase as few as one share.
Another advantage is that the expense ratios for most ETFs are lower than those of the average mutual fund. When buying and selling ETFs, you pay the same commission to your broker that youÂ´d pay on any regular order.
Oil and Gas â€“ One of the main advantages of oil and gas investments are the tax benefits. In an effort to reduce U.S. dependence on foreign oil and gas, Congress provides tax incentives to private investment sources that finance U.S. operations. Investing in oil and gas can be one of the most tax-advantageous investments available. The Tax Reform Act of 1986 exempts oil and gas working interests from being classified as passive income. Also, oil and gas investors can write off their intangible drilling costs, (IDCs) which account for the majority of the dollars invested in finding and developing domestic oil and gas wells. An IDC is defined as any expenditure that in itself does not have a salvage value and is incident to and necessary for the drilling of wells for the production of oil and gas.
Typically, intangible drilling costs make up roughly 75 percent of the total investment, creating a tax-sheltering effect. IDCs are deductible in the current tax year, even if the well does not start drilling until March 31 of the year following the investment.
The remaining 25 percent of oil and gas investments include tangible drilling costs (TDCs), leasehold costs, etc., which are not fully deductible in the current tax year, but may be depreciated over a five- to seven-year period.
The first 15 percent of income is tax free. The 1990 Tax Act provides special tax advantages for the typical investor in oil and gas drilling projects. Currently, the percentage depletion allowance treats 100 percent of an investorÂ´s first 15 percent of oil and gas income as tax-free. This number has fluctuated over the years and will continue to do so. Although owners of working interests in oil and gas properties are subject to the alternative minimum tax, they are exempted from the passive income limitations. This means that the working-interest holder, who manages the development of wells and incurs the cost of operations, may use oil and gas losses to shelter income from other sources.
Timberland â€“ Timberland offers many appealing benefits to investors, such as portfolio diversification, excellent returns and low-risk investing. Timberland returns are negatively correlated with the traditional equities market, and move independently from other asset classes.
Income is generated through timber sales and other activities such as hunting leases and participation in various government programs while the timber is growing. In most instances, the profits from the sale of land and timber are treated as capital gains.
Timberland investments have produced equity-like returns with bond-like risk. Trees grow in value regardless of market conditions. Also, timber can be harvested when prices are favorable or remain as a growing tree until prices are better.
Farmland â€“ A growth and income investment, farmland is not solely an income like a real-estate investment trust (see REITs next page), but it is not a growth stock either. It is a blend. Farmland has some very interesting advantages over other alternative investments. Firstly, farmland is always in high demand. As opposed to other real-estate investments, you do not have to worry about vacancies. The demand is so high that leasing farmland is typically performed by auction.
Because of its lack of improvements farmland typically does not have depreciating structures to worry about as the investment matures. In contrast to a building that breaks down over time, farmland can become more fertile over the years if treated properly. Maintaining drainage, water supply and soil fertility will keep the property as an appreciating income-producing asset for years. As with oil and gas investments, the government promotes the ownership and maintenance of farmland to curb U.S. dependencies on foreign commodities. Through subsidies and regular tax benefits associated with real estate, the government makes it clear that farmland is a favored investment.
A wealth of information on average farmland values and cash rental rates going back as far as 1930 can be found at www.usda.gov. Enter â€œEconomic Research Serviceâ€ in the search field and then search for farmland values. As an aggregate, the annual returns are approximately five percent cash on investment and a little over five percent capital appreciation.
Like all investment classes, there are many types of farmland that offer different rates of appreciation and risk. California or Southwest irrigated farmland has higher returns than average. Specialty crops such as lettuce or avocados, walnuts and almonds can cause an overall return of as much as 10 times the amount of more stable farmland. Obviously, there are higher associated risks with the stronger returning land and crops. Proper management of farmland is important to keep the land producing.
The cash-flow stream and long-term historical trend in most farmland real estate makes it a interesting alternative investment.
We would like to thank Halderman Farm Management Service, Inc. for their help with this section of the â€œAlternative Investmentsâ€ feature. Halderman manages approximately 180,000 acres of farmland and approximately $500 million in farmland assets. They have been farmland-asset managers and investment advisors for three generations. For more information, contact Howard Halderman at 260-563-8888 or visit www.halderman.com
Tax Liens â€“ Tax liens are notes on property tax that are sold by the majority of states in the U.S. to anyone willing to bid for them. Basically, all you are doing when purchasing a tax lien is paying the defaulted real-estate taxes on a specific property. A lien is issued and you are helping the state (specifically the county) with its cash flow. This is probably the most secure investment that can be made. The property cannot be purchased without paying off the lien with interest â€” on average about 16 percent â€” first. These are government-backed notes on a property usually worth a large multiple over the value of your lien. Like most alternative investments they are not liquid. One of the hidden advantages of tax liens is that in some states that sell them you can end up owning the property if you are not paid within a set period (e.g., two years in Michigan). A highly recommended book on tax liens is The 16% Solution by Joel S. Moskowitz.
REITs â€“ A real estate investment trust is a security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages. It receives special tax considerations, and typically offers investors high yields as well as a highly liquid method of investing in real estate. There are three main types of REITs:
Equity REITS invest in and own properties, and are thereby responsible for the equity or value of their real-estate assets. Their revenues come principally from their propertiesâ€™ rents.
Mortgage REITs deal in investment and ownership of property mortgages. These REITs loan money for mortgages to owners of real estate, or purchase existing mortgages or mortgage-backed securities. Their revenues are generated primarily by the interest that they earn on the mortgage loans.
Hybrid REITs combine the investment strategies of equity REITs and mortgage REITs by investing in both properties and mortgages.
The most diverse alternative investment group is comprised of hedge funds. They are unlike the other alternative investments mentioned in this article. The main difference is that a hedge fund is not a type of investment, it is really a legal structure. Most of the alternative investments mentioned in this article are specific classes of investing that are very often in use by hedge funds. Still the majority of hedge funds invest in securities and use their access to leverage and short-selling to increase returns and/or manage risk. Because we recognize the increasing accessibility of hedge funds and their popularity amongst investors and brokers alike, the remainder of this article will address this type of investment vehicle and how your brokers can use it to retain and attract new customers.
The first known hedge fund was started in 1949 by Alfred Jones, a financial journalist with a PhD in sociology, who wanted to create a lower risk method of stock-market investing. He would take long positions in undervalued stocks and balance them with short positions in overvalued stocks. The idea was to neutralize the risk of a change in market direction and still get a decent return.
The investment vehicle was set up as a limited partnership (Originally a general partnership and changed to a limited partnership a few years after its inception). An incentive fee of 20 percent of the profits was used to force the manager to make money and to not just spin wheels. It was not until much later that a management fee of one to 1.5 percent was applied by hedge funds. The term â€œhedgeâ€ did apply to this first fund. Although many of todayâ€™s hedge funds use this method of hedging risk, the vast majority just use that type of vehicle to fund a whole spectrum of investing strategies.
Hedge funds and your business
Many businesses have to make regular adjustments to their product and service offerings in order to keep their clients happy. Brokerage firms have generally been practical about providing their reps access to new investment vehicles. There is always a balance to strike between the value to the client, the fees earned by the rep and firm, and the cost or potential cost to the firm. As hedge-fund investing crosses over into the mainstream, the perceived value to clients is increasing. The potential fees to be earned are good. The costs and potential costs to the firm are still present, but are definitely decreasing.
The demand from reps has been increasing in proportion to investor demand. As always, competition in the financial advisory arena forces advisors to monitor investment trends and to be ready to provide their clients with the products and services that the investors expect. As investors become more knowledgeable, and competition for control of their assets becomes fiercer, financial advisors must provide more services for lower rates to remain competitive. Many of the larger firms have generally focused on the wealthiest one percent of the nation, accredited investors who are the primary target market for most financial advisors. The larger firms usually have the capital and/or the in-house talent necessary to expand their capabilities quickly.
The recently ended bear market helped to focus many investorsâ€™ minds on the risks associated with pure equity investments, and restored some of the perceived value for investment advice versus index-based investing. Advisors who used a different mix of investment products and helped investors preserve their capital in the down markets have been much more successful in retaining old clients and attracting new ones. Numerous studies have shown that hedge funds can be a valuable addition to an investment portfolio because they provide additional diversification among other benefits. As wealthy investors become more aware of the advantages of hedge funds, advisors and investment firms are finding that the introduction of hedge funds as part of an investment product line can be a strong competitive advantage today. Wealthy investors will require that advisors provide hedge funds as part of their overall portfolio, and gravitate to the firms and advisors who can provide access. The assets held by hedge funds have grown enormously in the past decade and look set to continue their growth.
Our thanks to the friendly people at Van Hedge (www.vanhedge.com) for some of the information in this article.
The SEC and you
The massive growth of the hedge fund and its rising status as a mainstream investment vehicle have elicited a regulatory response. The government is already encouraging hedge funds to register with the SEC. The SEC has further decided that hedge funds with more than $25 million in assets will be compelled to register by February 2006. This has the potential for both good and ill. The potential good is that SEC regulation of hedge funds will probably reduce some of the liability involved in selling hedge funds. The potential danger is that reporting requirements will generally hamper hedge fund managers. One reason given for hedge fundsâ€™ superior performance compared to mutual funds has been their relative freedom to pursue different investment strategies. Making hedge funds more transparent might dissuade hedge fund managers from taking some of their positions. However, the lowered liability is probably more important than the possibility of adverse effects on hedge fund performance from the perspective of a firm or manager.
Costs and benefits
The primary benefit is, of course, providing your reps with the ability to diversify their clientsâ€™ portfolios with hedge funds where appropriate. Done correctly, this will provide clients with better returns at lower total risk.
Another benefit to hedge fund sales is being able to add directly to the bottom line. There are good commissions to be made from brokering investments into hedge funds. Hedge funds typically receive a one-percent fee management plus 20 percent of profits. Funds of funds generally receive at least an extra one percent â€” usually more, and often with an additional profit incentive. These hedge fund fees leave a great deal of room for commission, which can take a variety of forms. There can be a straight fee, a fee based on assets, or an annual royalty. Standards of commission are still evolving and will probably trend downward, but are currently favorable for firms. The costs can be high, too.
The billion-dollar mistake
Throughout the 1980s and early nineties, Prudential-Bache offered an array of investment-oriented limited partnerships. The commissions were good for both the firm and the reps who sold them. In theory, the limited partnerships would enable the money managers to make investments in many less regulated fields in the pursuit of better returns. Sound familiar? The unfortunate reality for both the investors and Prudential was that many investors lost money in the less-regulated and loosely audited investments made through Prudential. Bad luck can hit any investment. However, illiquid and poorly-audited vehicles allow the managers to easily hide poor performance and entice more money into their control. Well over 100,000 claims were filed against the firm and the eventual payout on the claims was approximately a billion dollars.
The good news is that increased SEC regulation of hedge funds can help ameliorate the possibility of such a disaster for your company. The chances of problems within the hedge fund industry still exist, but they will probably be similar to the chances of fraud and incompetence in standard investments.
Poor sales practice is still a danger. As with high-yield bonds and small company stocks, hedge funds will probably be a source of complaints from investors who didnâ€™t understand what they bought. These misunderstandings can be the result of poor investor education. Reps in your employ may be tempted to push the wrong hedge funds to the wrong type of investor, especially if the commission structure is favorable to the riskier investments. Many of the reps will probably also not understand the nuances and dangers of particular alternative investments. Some of the products can lead to unexpected tax liabilities for profits that are inaccessible. Many of the hedge funds will have performances well-correlated to certain sectors of stocks. An ill-informed rep or team of reps may attempt to diversify their clientsâ€™ portfolios with alternative investments, but actually cause a much more vulnerable investment strategy. The general concept of diversification is usually good, but mistakes in execution can be disastrous. For example, a portfolio split between bonds, equities and hedge funds would normally be considered diversified. However, if your reps choose financial-sector equities and hedge funds that use a great deal of leverage in their strategies, the result will be a disaster every time interest rates increase substantially.
There are a few other dangers of alternative investments of various stripes. Anything that does not have a reasonably deduced market value at the end of each business day can be vulnerable to competing valuations in cases of contested ownership and/or tax liabilities. This will generally not be an actual liability to your firm, but it can steal extra time and effort from you and your reps.
Finding hedge funds
There are now several thousand hedge funds in existence. Numerous companies now classify and analyze hedge funds. Van Hedge Fund Advisors, CSFB/Tremont, Morgan Stanley, the Hennessee Group, and Hedgefund.net are among the companies that have developed databases of hedge funds along with indexes and classifications. Many of the most famous hedge funds are now closed to new investors, but there is usually good access to funds of funds which often have better access to the larger hedge funds.
Most of the resources devoted to hedge funds are not aimed directly at stockbrokers or small brokerage firms. A few hedge fund industry participants (including George Van of Van Hedge Fund Advisors) acknowledge that financial advisors will play a role in the expansion of the hedge fund industry and that smaller brokerage firms will begin to provide hedge funds as investment options. There are a few services aimed at helping firms start their own hedge funds. Depending on the size of the firm or practice within the firm, these may be a viable option. For most small firms, it is almost certainly better to choose from among the current hedge fund advisors. There is less initial cost in both time and money.
Food for thought
Hedge funds and other alternative investments are not new. Hedge funds have peacefully coexisted with other investments for over half a century. Some of the other alternative investments are even older (as old as the treesâ€¦). However, a combination of factors has brought hedge funds into the mainstream world of investments and into competition for the attention and money of wealthy investors. Many of the other alternative investments will follow suit in the future. You and your reps will probably have to accommodate your larger customers with access to hedge funds and other investment vehicles. The good news is that while this is a moderately difficult task, it may become a good source of profit in the years ahead.