NOW MORE THAN EVER, institutional investors are being urged to allocate funds to alternative investments. The conventional wisdom is that this kind of portfolio diversification will improve future returns, because returns from these non-publicly traded investments are not correlated with those of conventional asset classes.
While it is true that in many cases, asset classes within the alternative investment universe have significantly outperformed equities and fixed income without obvious evidence of increased risk, it is also true that there is no free lunch – investments promising outsized returns are always associated with significant risks that may not be appropriate.
The key to deciding whether to make an allocation to an alternative investment asset class is having a strong understanding of what is available and of the not-for-profit organization’s ability to understand the product.
Most investment professionals lump any investments that are not publicly traded stocks or bonds into an alternative investment category. Using this definition, some alternative investments have a relatively extensive history. Private equity funds, commodities and even real estate often are deemed alternative investments. In fact, most assets with infrequently determined prices and valuations probably would fall into this category.
The lack of price transparency is evidence of a lack of consistent investor interest in a product, which poses significant risks for investors. For this reason, access to these asset classes has traditionally been limited to very sophisticated investors, including the largest institutions.
In the last decade, more investors – including pension funds, endowments and universities – have gained access to alternative investments. More recently, absolute return strategies, commonly referred to as “hedge funds,” have become a major part of the investment markets.
Eager to earn higher returns, institutions have hired managers that use extremely complicated strategies. Among these strategies, quantitative model-driven approaches, shareholder activism and strategies that borrow money or use derivatives to enhance returns have become both popular and a source of concern.
Absolute return strategies, the newest and most esoteric form of alternative investments, likely pose the greatest risk to a not-for-profit and are the most difficult to understand.
As not-for-profits look for efficient returns, they need to be knowledgeable about alternative investments before approving an allocation. On a simple level, alternative investments are often inappropriate. Where use of the products is appropriate, research and the education of all responsible fiduciaries is important.
When considering an investment, it is critically important to understand any and all strategies, have clearly defined contractual obligations and demand timely, detailed disclosure.
Failure to understand the risks associated with alternative investments is not an acceptable excuse if problems arise, according to the American Institute of Certified Public Accountants. Even the Securities and Exchange Commission has been pushing for restrictions designed to ensure that all parties involved understand strategies and their risks.
In the end, most alternative investment managers promise excess returns because they claim a superior understanding of particular markets. In some cases, the purported intellectual advantage is overstated, or the manager loses whatever edge he or she had exploited to produce high historical returns. If this happens, stewards could be held accountable.
Another purported advantage of alternative investments is the lack of correlation to more traditional, publicly traded investments. Because of this historical lack of correlation, it is difficult if not impossible to model and predict future returns based on historical performance. Not-for-profits should remember that there are currently no proven tools to forecast returns or predict consistency of returns.
In addition to the lack of disclosure and understanding, the lack of uniformity among alternative investments contracts is a source of risk. Contracts are usually designed to limit investors’ ability to exit an investment. Knowing when and under what circumstances invested funds can or will be returned is important.
Some funds, especially private equity funds, often reserve the right to request additional investments in the future. In these situations, not-for-profits may be committing to stay in an investment even if future events negatively affect return expectations. For some not-for-profits, the inability to demand the return of invested funds increases the risk of violating a debt covenant or internal policy. These are important considerations in deciding to allocate funds to alternative investments.
Many absolute return managers demand secrecy and loose disclosure. This creates serious potential problems for not-for-profit investors. Most not-for-profits have financial reporting requirements that require timely disclosures of investment valuations and returns. Many managers’ strategies are so esoteric that timely financial disclosure is difficult. Some take months to send valuations. Oftentimes, the data that are disclosed are vague and ambiguous.
In the past two years, the inability to determine the real value of some investments has led to big losses as managers were forced to inform investors that estimates of the values of investments were too high. In other cases, the lack of potential buyers and sellers of certain investments held by the fund created unexpected rapid declines in value. These cases demonstrate some of the significant risks borne by investors.
Should a not-for-profit invest in nontraditional assets to enhance returns? The answer lies in the organization’s ability to fully comprehend the various risks. For a well-qualified board with a full understanding of selected strategies and the associated risks, exposure to alternative investments may be appropriate.
However, alternative investments are not for every investor. Not-for-profits should make sure they have been properly educated and are comfortable with all associated risks before venturing beyond traditional asset classes.
E. Todd Truitt authored this article while with the Lancaster Pollard Investment Advisory Group, an SEC-registered investment adviser that helps not-for-profit organizations create the financial means to last the life of their missions by helping them manage total financial risk.