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Don't open your wallet to an investment pitch you don't understand.
Chuck Jaffe, CFO Magazine
May 8, 2006
Success has its side effects. One is that it puts you directly in what money professionals call the "seller hit zone." That's the place where executives become a target for anyone with a slick sales pitch and an investment opportunity that is supposedly "necessary" for building and protecting wealth.
To those who have worked their way up the corporate ladder, that first opportunity to get into a hedge fund, or to buy an alternative investment product, is like an invitation to join an elite country club. The problem is, many executives fail to look closely enough at what they're getting into.
"What happens with CFOs and high-level executives is that they're very bright people who are on every seller's radar screen, and who could figure out all of these investments if they had the time," says financial adviser Diahann W. Lassus of Lassus Wherley & Associates in New Providence, New Jersey. "But the reality is that they do not have the time and many of them wing it, because they know enough to understand how they could benefit from the investments without knowing all of the pitfalls."
The pitfalls in alternative investment products are plenty, running from simple high costs and fees to the potential to get ripped off. And salespeople have been pushing these investments hard, given the low returns from conventional investments over the past few years. (See "Three for the Money" at the end of this article.)
Sorting through alternative investment opportunities requires self-awareness, patience, and an ability to turn down the ego. Above all, there's no substitute for doing your homework. Just as you wouldn't hedge a corporate risk with a derivative you don't understand, so you shouldn't put a chunk of your personal wealth in an investment you don't understand.
One of the biggest areas of opportunity, and concern, for high-net-worth investors is hedge funds. For years, these unregulated private-investment pools were available only to the superrich, with most requiring a $1 million minimum investment. Today, however, there are thousands of hedge funds, some accepting new investors for as little as $50,000.
Compared with the orderly world of mutual funds, with its custodial controls and requirements, hedge funds are the Wild West. Larry Eiben, a partner at TFS Capital LLC in Richmond, Virginia, recalls opening his first hedge fund by "setting up a bank account down the street and taking the money people sent in and putting it in that checking account."
While many advisers love including hedge funds in their clients' portfolios, they can't deny that the world of hedge funds has its own laggards and losers. Size is no protection from disaster; witness the spectacular failures at Tiger Management, Marin Capital Partners LP, and Long Term Capital Management, to name just three. It's healthy, says Eiben, to think of hedge funds as "scary," because "what you don't know can hurt you."
The same can be said for some variable annuity products, equity-indexed annuities, private stocks, limited partnerships, and more. "A lot of these alternative [investments] just don't add a lot for most people," says Les Nanberg, president of Cornerstone Wealth Management LLC in Boston. "They make an interesting story, but you really have to question how much value they add. Perhaps the most important thing to remember when someone is trying to sell them to you is that you can live without them and still reach your goals."
In the end, it pays to remember a simple rule of thumb: if you can't explain an investment pitch to someone in 25 words or less, you may not know enough to go it alone. Direct the pitcher to your financial adviser, if you have one, because this is just the kind of help you're paying for. And if you don't have a planner, consider hiring one. You will almost always be better off shopping around and picking your own expert, instead of allowing someone selling investment products to pick you.
To learn more about alternative investments, consult the following resources:
MAR/Hedge is an independent research firm that tracks developments in the business and performance of nearly 2,000 hedge funds.
Hedge Fund Center has a mission of providing objective educational information on all aspects of hedge fund investing.
The Hedge Fund Association is an international group of hedge funds, but its site will help you learn about the wide range of what is available, and will keep you abreast of news in the industry.
The Securities and Exchange Commission has an outstanding primer on equity-indexed annuities.
AnnuityAdvantage.com has information on many available annuities, allowing you to do comparison shopping.
Chuck Jaffe is senior columnist for MarketWatch.
Three for the Money
Popular Alternative Investments
Hedge funds. Loosely regulated private-investment funds that have been growing steadily in popularity, traditional hedge funds use various strategies beyond buy-and-hold to try to make money in all market conditions. The biggest, most well-established funds are open only to "accredited investors," which means people for whom a lot of money is not a big chunk of total assets.
The funds can rely heavily on leverage to increase gains, and sometimes make oversized bets on hard-to-quantify risks. They have very little reporting to do, and their performance can be hard to compare with that of their peers. And the cost can be high: in addition to an annual asset-management fee (typically 1 to 2 percent), the fund manager keeps 20 percent of the profits before shareholders get the rest.
Separately managed accounts. The idea here is that you have a portfolio of stocks and bonds that is managed by either your financial adviser or a professional money manager for your specific needs. Unlike a hedge fund — where there is no transparency and you have no real idea of how your money is invested — separately managed accounts let you see precisely what you have. This also helps you manage the money in a tax-efficient fashion.
That said, separately managed accounts aren't always as "separate" as they seem, as the adviser tends to run all client money the same way. In addition, there is no guarantee that performance will be any better than an ordinary mutual fund, because there is no reason to believe that the average money manager running private accounts will do better than the average fund manager. What is guaranteed is costs, as separately managed accounts tend to be more expensive than mutual funds, often two or three times pricier than the average fund.
Equity-indexed annuities. The selling point here is a promise that you will get "some" of the stock market's return, with the added promise that you will never lose money no matter how ugly the market gets. Technically, an EIA represents a contract between the buyer and an insurance company. The insurer typically guarantees a minimum return, provided the money stays in place long enough. This is a devil-in-the-details product, as the fine print often determines just how attractive it really is, and how limited the potential upside is.
EIAs are popular with the people selling them because they generate big commissions. For buyers, they are right only for those who understand the terms and conditions and are willing to stick with the product through several years of high surrender charges to actually achieve the returns promised in the sales literature. — C.J.