By Carrie Coghill Kuntz

Published October 2007

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It is hard to turn on the financial news or read the business pages of the newspaper without hearing or reading something about alternative investments. As the traditional investment markets increase in volatility and deliver sub-par results, investors are looking for different ways to make money. Many individual investors are coming in contact with the concepts classified as "alternative," without truly understanding the proper benefits, uses, and risks. The alternative investment industry is broad, but it is worth exploring, in order to help investors truly achieve diversification. The most simplistic definition of an alternative investment is one that offers low correlation to traditional investments, such as stocks and bonds. Alternative investments still have volatility, in some cases more so than traditional investments, but the reasons that these investments fluctuate can be very different from the factors that affect the traditional investment markets.

The benefits of alternative investments can make it well worth the effort of learning about these products. The popularity of this sector increased dramatically following the bursting of the stock market bubble from 2000 to 2002. While the stock market lost almost half of its value over this time, many alternative investment categories performed extremely well. Instead of just focusing on how their investment portfolios are performing relative to the U.S. stock market, individual investors are now striving for a strategy that can provide more consistency of performance over time. The collapse of the stock market from 2000 to 2002 was a painful experience. Most people had never experienced this type of financial pain. Today, over 50 percent of all U.S. households have investments in mutual funds. The last time the stock market delivered a decline of this magnitude was in the 1970’s when less than five percent of U.S. households held mutual funds. The growth of wealth in our nation is of significant importance when understanding the rising popularity of this investment category.

Although there are many different types and categories of alternative investments, some of the most popular are real estate, oil & gas programs, hedge funds and private equity.

Real Estate. As an asset class, real estate exposure can be an essential sector in achieving diversification within a portfolio. What I like most about real estate is that you can see it, feel it and touch it. It is not just a piece of paper that can become worthless. If you own a piece of property, it never just disappears – like Enron did. Real estate can provide a current stream of income for investors and the potential for appreciation. There are several ways that investors can participate in the real estate market. For example, you can purchase an apartment building, manage it and reap the rewards of rental income. Someday, you can then sell the property (hopefully for more money) and benefit from appreciation. But, many people are too busy managing their lives to want to take on the task of buying and managing their own real estate. Another way to invest in real estate is through a private real estate investment trust (REIT). Private REITs offer investors the ability to pool their money with other investors and have a management company select and manage real estate properties. All private REIT programs offer various objectives, types of real estate, locations and potential for returns. Many offer current income with the possibility of capital appreciation, when the program liquidates.

Oil & Gas Programs. These programs are typically set up as limited partnerships, where one or more general partners manage the business, while the limited partners contribute capital and share in the profits, but take no part in running the business. General partners remain personally liable for partnership debts, while limited partners incur no liability with respect to partnership obligations beyond their capital contributions. Oil and gas limited partnerships fall into two categories: exploration/drilling programs and income programs. Drilling programs involve ventures engaged in exploratory drilling for oil & gas. If you are an investor in a drilling program limited partnership, you may be able to deduct certain costs on your personal income tax return. Later, if oil or gas is discovered, you will also share in the net proceeds. Income-oriented limited partnerships, by comparison, are ventures that purchase the reserves of proven wells (wells that have already been drilled and contain oil & gas). These ventures emphasize generation of income. High net worth investors are drawn to these investments for the potential tax deductions offered and lack of correlation to other investment categories. As always, investors should consult with their tax advisor before entering these programs.

Hedge Funds. Hedge funds are typically private, pooled investments that employ sophisticated investment techniques to hedge against market declines. In recent years, these vehicles, which were once available only for accredited investors, have become more accessible to retail investors. It is important to keep in mind that the term "hedge fund" is very broad. Hedge funds can employ a wide spectrum of management philosophies and ways of enhancing performance. They can be highly concentrated or invest in several different hedge funds (referred to as a "fund of funds"). Many funds use leverage (borrowed funds) to enhance returns, along with different types of products, such as commodities, currencies, etc. Depending on the structure of the particular product, hedge funds may be exempt from many of the federal securities laws, such as the Investment Company Act of 1940 and the Securities Act of 1933. Therefore, these products may not offer investors the protection commonly associated with these acts. Examples of protection that may be lacking with these product types included limitations on the use of leverage, protection against conflicts of interest, requirement of certain liquidity provisions, and limits on how much may be invested in a single investment.

Private Equity. As with hedge funds, "private equity" is a broad term. Any ownership interest, or equity, in an asset that is not a publicly traded security is considered to be a private equity investment. These funds are typically set up as limited partnerships whereby qualified investors contribute to the general pool of funds which are managed by the partnership’s general partner. Private equity programs can be very different in terms of how they invest the program’s money. Typically, they invest in other companies where they feel there is opportunity to add value and see the company grow. Private equity firms can invest in a wide range of companies from very small idea companies (angel investing) to large publicly traded companies. Generally, private equity programs require that investors are accredited (net worth over $1 million or income exceeding $200,000 for individuals, $300,000 for couples), recognition that these programs are long-term (sometimes require a 10-year commitment), have high initial minimums, and are illiquid. When considering all of these guidelines, why would an investor want to get involved in private equity? Successful private equity firms have been able to deliver annual results in the 30 percent range. These results would be difficult to consistently find in the publicly-traded markets. In addition, because these investments are direct investments into companies, their performance does not necessarily correlate with the stock market. Eliminating the emotions of the publicly traded markets is useful in enabling private equity managers, companies and investors to stay focused on their objectives.

In dealing with alternative investments of any type, there are many risk factors that need to be considered. It is imperative to conduct adequate due diligence by understanding the liquidity of the product, the exit strategy of the product, creditworthiness of the issuer, creditworthiness of any underlying collateral, risks associated with security of principal, return, and/or interest rate risks. Many of these programs specifically acknowledge that it is possible to lose principal. In addition, be sure to understand the tax consequences and the costs and fees associated with purchasing and selling these investments.

We are all busy with our careers, who has the time to do all of this research? My advice is to rely on a professional that has expertise with alternative investments. In the alternative investment world, relationships are essential, in order to understand the intricacies of the programs and ensure that the risks associated with these programs are properly matched with the risk tolerance of the investor.

Alternative investments can be complex to understand and have a wide range of risks associated with them. However, if used properly, they can help to truly diversify an investment portfolio. The objective should be to use these products to complement a traditional investment portfolio. The result may be reduced overall portfolio risk and the opportunity for increased return. Given the volatility that we have been experiencing with the U.S. stock market, it may be worthwhile to explore alternative investments. Just make sure your selections are suitable for you!

Carrie Coghill Kuntz is a Certified Financial Planner and President of D.B. Root & Company Wealth Management in Pittsburgh, Pa. She is a registered representative of Commonwealth Financial Network, a member of the FINRA/SIPC.