Alternative Assets in Summary:
- The investment universe is vast – and thus there are many different types of investments available to you. In an effort to save you time and headaches (and to prevent me from getting a wicked case of carpal tunnel syndrome), we are combining many of these asset classes together in this section.
- Many of these investments are either unattractive long-term assets to hold, or they require large minimum investments – thus either being unavailable and/or unfavorable investments for young professional investors. Also, considering how vast, varied and complex they are, and without proper knowledge of them, they might be difficult to invest in.
The types of investments we have reviewed thus far are the ones you will most likely encounter or already have seen at this point in your investment life. The following is a list and brief description of other asset/investment types that you may find available to you, but in most cases, you should just ignore them.
Just a fancy word for “goods” – this asset class has recently gained favor as an investment usually with the intent to benefit investors in the case of inflation (the general rise in prices). Commodities such as gold and oil have gained special attention due to their recent dramatic volatility in prices, but commodities cover a wide array of items like wheat, cattle/pig meat, metals like iron and copper, and much more. As an investment class, the annual long-term return on commodities has been less than inflation, essentially making NO money. Forget it.
Though in some periods commodities have outperformed many investment types (including stocks), it is confusing to hear their long-term investment case. Many times commodity investments are used by agents in their industry to control their pricing – for example, a cattle farmer buys a commodity investment that will help them lock in a price for when they sell their cattle in a year. But when you buy a commodity investment you are just hoping for a gain in the price of the good over time…there is no coupon interest payment or a dividend from the commodity investment like we saw in previous investments.
Over the long-term, technology improvements have made it easier and more efficient to mine or grow these commodities, thus allowing for prices to decrease. On the other hand, a major case for investing in commodities is that emerging economies like China and India are growing their demand for many of these goods and that a limited supply will cause prices to grow. But, the likely better long-term investment option here is to invest in a company that harvests and sells these goods instead of the actual goods themselves! That way you benefit in the success of a company (through those long-term bets we mentioned in the previous section on stocks) and also a potential gain in the commodity price.
Mortgage Backed Securities (MBS):
This investment type was a key fuel for the financial crisis – but yet many of them these days aren’t that dangerous. Previously banks would issue mortgages to homeowners, then bundle up a few thousand of them and sell them off to other investors as a mortgage-backed security…thus no longer holding the mortgages as investments for themselves. The problem arose when many of these mortgages were issued to people who couldn’t afford them … so when they couldn’t pay their mortgage the investors in the MBS had to take significant losses.
The reason why some of these investments are actually safe is that many of them are guaranteed by the federal government. Companies such as Fannie Mae and Freddie Mac offer a guarantee on certain types of mortgage-backed securities, and these companies are now under the control of the federal government (since they lost billions of dollars during the financial crisis and would’ve gone bankrupt without Uncle Sam’s help). So, mortgage-backed securities issued by these agencies are technically backed by the federal government.
When you invest in a bond fund many managers will allocate money primarily to corporate bonds but also to mortgage-backed securities and Treasuries for extra diversification. But, you likely won’t have the ability or need to know how to invest directly in an MBS due to their lower long-term return potential and high required initial investment rates.
Insurance companies offer many different types of annuity products that can combine features of an investment as well as an insurance product. A fixed annuity is an investment which guarantees a buyer a certain fixed flow of income when they retire. The buyer agrees to contribute a fixed amount over the course of their career (or all at once) and the insurance company guarantees to give them a steady stream of money in retirement. Sounds good right? But, you can do this yourself even better! Avoid the high fees associated with an annuity and put your money to work with stock investing to receive much higher returns during your career. Then in retirement, you can make your portfolio more conservative by adding bonds and replicate a higher ongoing income relative to the annuity by spending from your investments. Don’t be misled by “variable annuities” which offer gains based on stock market movements – for example, the insurance company contracts vary considerably and might limit your monthly gain to 3% even if the market is up 6.2%. Wonderful. And be careful of hundreds of pages of hidden costs and schemes, not worth it!
Private Equity and Hedge Funds:
We have lumped these two together since you fall into the category of “You are not broke, but not loaded,” and you need in many cases upwards of $1 million to purchase into each of these types of investments. Once you invest in either type of these funds you could lose the right to get your money back in some cases for up to several years (low liquidity). Private equity funds use the money given to them by investors to buy out small companies or publicly traded companies, restructure them, and re-sell them to the public for a hefty profit. Hedge funds use a variety of trading strategies to generate profits in many cases that are unassociated with the general movement of the market (in some cases generating riskless “arbitrage” profits). Since these funds are normally run by the self-acclaimed “God’s gift to the financial world” they normally charge a 2% fixed fee and take 20% of the profits they make for you. Though in many cases the managers of these funds are incredibly intelligent, this is still an absurd fee for managing your money. As seen during the financial crises, maybe these fund managers weren’t as invincible as they thought they were. Some private equity funds were unable to resell many of the companies they bought at the highest prices in 2007, and several hedge funds used “levered” bets where they borrowed money to bet 20:1 on certain investments … and when they were wrong some funds went completely broke (ie investors lost close to everything). Or, in cases like the Bernard Madoff Ponzi scheme, they didn’t invest your money at all and laundered the funds and used them for personal expenses! The low liquidity, high investments required, the lack of transparency into what these funds are buying/selling, the higher risks, and the high fees are all good reasons you can’t buy and should avoid buying these investments.