How to Evaluate Alternative Stock Investments
Alternative stock investments such as closely-held stock typically will not add the diversification benefits that an investor maintaining a diversified, long-term investment portfolio should seek to gain from investing in alternative assets. Some high-performing alternative stock investments may be evaluated on their own merits, but there are many alternative stock investments set up as vehicles for investing in alternative asset classes, and they should be evaluated carefully.
Your primary objective in investing in alternative assets should be to expand into asset classes with low or negative correlations to the stock and bond portions of your investment portfolio. Pay special attention to correlations during times of crisis, when asset class correlations tend to rise. Real estate can make a solid addition to your portfolio, but public equity real estate investments such as real estate investment trusts and real estate operating companies often exhibit risk-return profiles very similar to stock market investments.
Evaluating any investment involves an examination of historical risk-adjusted returns, both short-term and long-term. Marketing literature often contains disclosures regarding asset managers, which can be used as a basis for further research. Many asset managers promote their abilities to participate in market gains while minimizing losses during years the broader markets decline. You should be able to verify these claims. The literature also often contains numerous measures of historical returns, including risk-adjusted returns including Sharpe ratios, volatility and cash flow-adjusted returns. Analyze source data for these disclosures carefully, as alternative asset valuations can be highly subjective and, in some cases, non-current.
Investing in alternative stock investments generally comes at the expense of liquidity to some extent. You should expect to be compensated for taking on additional liquidity risk. However, if you obtain the same risk-return profile from investing in assets exhibiting greater liquidity without giving up diversification benefits, it is always prudent to invest in the more liquid asset. Sometimes, alternative asset managers with regular redemption policies are unable to make redemptions due to the illiquid nature of the fund’s underlying investments. In other cases, such as with some closely-held community bank stock, you may find thin secondary markets, allowing you to sell your shares if necessary. Regular cash distributions are one of the few factors that make illiquid investments more tolerable.
Alternative asset fund managers may charge a wide range of fee structures. Hedge funds generally charge annual fees equal to 2 percent of assets under management plus 20 percent of returns in excess of some stated base return or hurdle rate. Many funds end up as “zombie” funds, which continue to charge investors regular fees without generating any returns. According to consultants TorreyCove Capital Partners LLC, approximately 200 private equity funds accounting for as much as $100 billion of the $1.5 trillion currently invested in these funds have have been identified as zombie funds.