"Invest in us...Because you're worth it": Alternative Investments

Given the Security and Exchange Commission’s ruling this week that allows hedge funds and the like to advertise publicly, I can’t think of a better time to shine some light on what are known as alternative investments.

Alternative investments are called that because, well, they are alternatives to investing in regular stocks and bonds. Some of the most popular alternative investments include hedge funds, private equity funds, and venture capital funds.

Hedge funds are basically mutual funds for the ridiculously wealthy. A hedge fund pools money from different people or institutions, and invests in stocks on their behalf, but the fund doesn’t typically invest the way a mutual fund would. A hedge fund will invest in derivatives or sell stocks short, for example.

Private equity funds are similar to hedge funds in that they pool money from wealthy people and institutions, but these funds don’t buy or sell stocks that trade on the public markets. They buy whole businesses, sometimes by buying that company’s stock (which is known as “going private”) or buying it from its previous owners. Private equity funds generally invest in businesses with the intention of making them more efficient; after several years, the fund usually sells the company again, hopefully for a significant profit.

Private equity was talked about which a lot during the 2012 U.S. presidential election, as one of the candidates used to work for a large PE firm. Commercials featuring disgruntled employees he had “fired” from the companies riddled the airwaves. My personal opinion is that the attacks on the PE industry were unfounded and the candidate’s work was taken out of context. Rest assured that PE is not evil; it is very complex, but it is not bad.

Finally, there’s venture capital. If you watch the ABC show Shark Tank, you’re already familiar with the concept. Venture capital also pools money from wealthy investors, but these funds invest in companies that are babies, also known as start-ups. VC, as it’s known, is widely considered the riskiest of alternatives because the investments are in companies that are so unsure; many have not even made a profit yet. But the upside is that you can help an entrepreneur fulfill a lifelong dream that may be the next Google or Facebook.

All of these investments could potentially make you A LOT of money. But you know the drill: with high reward comes high risk. These investments are certainly more risky than buying Treasuries, and are generally more risky than investing in a stock index fund. BUT, there are a few other stipulations that make these investments even more out of reach:

• The minimum investment for these funds is typically $250,000 to $1 million, sometimes more.
• The fund managers generally get a 20% cut of the profit AND you have to pay about 2% per year to help them run the fund.
• Only “accredited” investors can play in the sandbox anyway.

That being said, if you start to see ads for alternative investments, most of us can only do just that: watch. But for those who could afford to play, be cautious, as with any investment, and know what you’re getting yourself into.