What are the Risks of Alternative Investment Funds?

Masterworks
October 19, 2021

Alternative investment funds are an easy way to invest in a basket of securities that are outside of the traditional stock market. Things like real estate, collectibles, hedge funds, art and more.

These assets are a way to diversify your portfolio and can be quite profitable on their own. Alternative investment funds are also beneficial in that they can be used to preserve capital in volatile markets while improving long-term risk adjusted returns.

With all of this said, alternative investments also come with some risk. Here’s what investors need to know.

Liquidity (or a lack thereof)

One of the biggest risks associated with alternative investments is liquidity. Unlike public equities, when looking at alternative investment funds, there is no guarantee that you’ll be able to sell it when you want to. If you hold stock through an online broker, it can be liquidated at any time (within reason). However, the same doesn’t hold true for alternative investments like private equity funds or hedge funds. In some instances, fund managers may only allow redemptions quarterly.

When investing in private funds, there’s also the risk of the ability to redeem to be temporarily suspended. Some funds do this when they believe redemptions may cause undue harm. This is a bad scenario for an investor who needs funds but cannot access them.

Another risk in terms of liquidity is lock-up periods. For example, a private equity fund may require investors to commit capital for at least five years. These periods make your money inaccessible for lengthy periods of time.

Leveraged portfolios

Often alternative investments funds lever up their holdings to seek higher returns. If successful, this approach amplifies the returns delivered to investors. However, on the flip side, these leveraged portfolios can also result in immense losses. Over the last few decades, there have been several notable hedge funds that have found themselves in a turmoil due to leveraged bets gone bad.

Valuation risk

Unlike public equities or a mutual fund, there’s no straightforward net asset value process when it comes to alternative investments. While some alternative investment vehicles, such as short and long hedge funds, operate based on liquid securities and bid-ask prices, others don’t. For assets that have no liquid secondary market, it’s extremely hard to set a value.

Valuation risk is highest with venture capital and private equity investments. Even though third-party valuation services are often used, fund managers ultimately report what they believe an investment to be worth.

This creates the potential for a conflict of interest. There are obvious incentives for fund managers to be biased in favor of higher nest asset value. In turn, investors may not be receiving an independent (or fair) valuation of the fund’s assets.

When it comes to mutual funds and other alternative investments, past performance doesn’t guarantee future results. There’s no promise that fund managers can replicate an enviable track record in the future. It’s not uncommon for investors to extrapolate the past into the future. But, there is no guarantee that today’s hot hand will be tomorrow’s hot hand.

Market risk

Investors also need to consider market risk. Anytime a fund is exposed to a particular currency, commodity, or business line, there’s market risk involved. Generally, market risk is unavoidable. It occurs due to sector cyclicality or a broad economic downturn.

However, the market risk for alternative investments tends to be much higher. Invest wisely!

High fees

Certain types of alternative investments carry higher fees than conventional assets. To make matters worse, the fees aren’t regulated, nor are they always straightforward. Because fees are based on the type of investment, they vary.

For example, the classic fee model for private equity funds and hedge funds is 2 and 20. This means that you’ll have to pay 2% of the managed assets along with a 20% performance fee.

Before investing, be sure that you not only understand the fees, but how and how often they’re charged. Some platforms take a percentage of each transaction while others charge maintenance fees.

Lack of regulation

While there’s some benefit in the fact that alternative investments aren’t well regulated, there’s also a lot of risk. These investments aren’t subject to conventional reporting requirements. Because it’s hard to value these assets, there are rampant issues of pricing and price transparency.

Investors also run the risk of fraudulent investments. There’s a much higher risk with alternative investments, especially collectibles, arts, and jewelry. If something can be faked, there’s always the chance that you’re buying into something that isn’t all that it appears to be.

Alternative investments are attractive for many reasons. There’s an increased potential for large returns and they aren’t correlated to the stock market. While there’s plenty to like about these investments, investors should be well aware of the downsides.

While it’s true that all investments carry some risk, it’s up to each investor to decide whether an alternative asset or fund is worth it. Before investing into an alternative asset, weigh the potential risks with the potential upside.


Masterworks
Masterworks is a fintech company democratizing the art market. Our investors are able to fractionally invest in $1mn+ works of art by some of the world's most famous and sought-after artists.