What are the Risks of Alternative Investment Funds?

October 19, 2021

Alternative investment funds are an easy way to invest in a basket of securities that are outside of the traditional stock market. Things like real estate, collectibles, hedge funds, fine art, and more.

These assets are a way to diversify your portfolio and can be quite profitable on their own. Alternative investment funds are also beneficial in that they can be used to preserve capital in volatile markets while improving long-term risk-adjusted returns.

What are Alternative Investment Funds?

Alternative investment funds (AIFs) refer to any investment vehicle that pools capital from multiple investors to fund a portfolio of alternative investments. Some alternative funds provide the option to invest across different asset classes such as hedge funds, private equity, gold, fine art, or other commodities.

Risks of Alternative Investment Funds

Risks will vary by type of asset and by fund manager, but the below are risks generally associated with alternative investments and alternative investment funds.

Low Liquidity

Unlike public equities, alternative assets are not traded publicly, meaning there is not an open market of buyers and sellers available to investors. If you hold stock through an online broker, it can be liquidated in mere minutes. However, for alternative investment funds, In some instances, fund managers may only allow redemptions quarterly.

Another risk in terms of liquidity is lock-up periods. For example, a private equity fund may require investors to commit capital for at least five years. These periods make your money inaccessible for lengthy periods of time.

Leveraged Portfolios

Often alternative investments funds lever up their holdings to seek higher returns. If successful, this approach amplifies the returns delivered to investors. However, on the flip side, these leveraged portfolios can also result in immense losses. Over the last few decades, there have been several notable hedge funds that have found themselves in a turmoil due to leveraged bets gone bad.

Fund Manager Risk

The alternative fund performance relies heavily on the experience and competence of the fund manager. Because these funds are actively managed, the performance can vary greatly from fund to fund even if the fund strategy is similar.

When it comes to mutual funds and other alternative investments, past performance doesn’t guarantee future results. There’s no promise that fund managers can replicate an enviable track record in the future. It’s not uncommon for investors to extrapolate the past into the future. But, there is no guarantee that today’s hot hand will be tomorrow’s hot hand.

Valuation Risk

Alternative investments are generally harder to value than traditional investments. Traditional investments like stocks and bonds have an official market price while most alternatives do not because they are not traded publicly on a secondary market. This leaves the valuation of alternatives up to the appraiser, leaving it relatively subjective compared to traditional markets.

High Costs

Historically, alternative investments have been restricted to accredited investors for the risks associated and for the initial investment minimums. Although that has changed significantly in recent years due to the adoption of Dodd-Frank and the rise of fractionalized investments, many alternative investment funds still require a high initial investment, especially compared to the near nonexistent minimum investment into stocks or bonds.

In addition to high initial requirements, there are also higher expenses charged throughout the lifetime of the fund. Due to the more complex structure and active management, alternative investment funds usually come at a higher expense ratio.

For example, the classic fee model for private equity funds and hedge funds is 2 and 20. This means that you’ll have to pay 2% of the managed assets along with a 20% performance fee.

Before investing, be sure that you not only understand the fees, but how and how often they’re charged. Some platforms take a percentage of each transaction while others charge maintenance fees.

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