If you’re investing in an instrument other than traditional stocks, bonds, or cash, then you’re investing in an alternative. In the current low-interest rate environment, many retail investors are allocating a greater portion of their portfolio to alternatives in search of higher yield. It is also common for investors to believe that alternatives help contribute to a diversified portfolio and reduce volatility. Originally offered to institutional investors and sophisticated, high net worth individuals, alternatives come in many shapes and sizes. They include private placements, precious metals, managed futures, structured products, commodities, currency, and “alternative alternatives” – just to name a few.
Let’s start by differentiating these from more traditional investments. Because alternatives frequently claim to have a low correlation with market indices, performance frequently depends more on manager skill than on market returns. Fees are often opaque and layered, and leverage may be used to magnify returns. One should also note that these investments can be highly illiquid. Their complexity explains their popularity among sellers, as complex products are often designed in favor of the issuer by having multiple layers of fees. In 2010, for the top five U.S. brokerage firms, alternatives generated $18 billion in fee revenues (McKinsey & Company: The Mainstreaming of Alternative Investments).
According to Financial Industry Regulatory Authority (FINRA) rules, broker-dealers have an obligation to provide their clients with adequate disclosures and follow suitability rules. The disclosures include such details as liquidity, leverage, associated fees, and conflicts of interest. With regard to suitability, broker-dealers must consider the investor’s age, risk tolerance, liquidity needs, financial and tax status, and other relevant characteristics (FINRA Rule 2111). Unfortunately, many broker-dealers have allocated a large portion of conservative investors’ portfolios to alternatives. When broker-dealers, enticed by high commissions, take advantage of retirement savers and elderly clients, investors may be entitled to compensation for their losses.
Furthermore, there is great potential for deception in the advertising of alternatives. Pay special attention to stability claims, extrapolation based on past results, and the omission of risk disclosures. For instance, structured products may have completely different risk/reward profiles than their reference assets. And in the world of private placements, the SEC has been investigating how firms value assets, record performance, and calculate fees. Purveyors of real estate investment trusts (REITs) may provide potential investors with inaccurate photographs and promise exposure to diversified portfolios when funds are really being directed to a single, highly leveraged project or to a limited number of projects.
“Alternative alternatives” are trendy yet risky! From art to fine wine to stringed instruments, these collectibles are highly illiquid investments whose markets are very difficult to track. An illustrative case study is fraud in French wine trade. While the Liv-ex 100 Fine Wine Index has had an annualized return of 10% since 2002, fraudsters have defrauded many investors in fine wines. They may change labels on less expensive Algerian wine so people think it’s from Burgundy. This can all be done more easily because of the lack of transparency and significant time delay between order and delivery – so watch out!
Silver Law Group represents the interests of investors who have been the victims of investment fraud. If you have questions about your legal rights, or have been the victim of investment fraud, please contact Scott Silver of the Silver Law Group for a free consultation at ssilver@silverlaw.com or toll free at (855) 755-4799.