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Q&A: As my wealth accumulates, should I invest in alternatives?

High-net-worth investors are often tempted to get fancier with their investing once their net worth opens access to more exclusive alternative investments (hedge funds, private equity ventures, non-traded REITs, etc.). Unfortunately, once you whisk aside the velvet curtain and take a closer look, high-end alternatives usually fall short compared to more straightforward solutions. Here’s why:

Risk and expected returns (still) go hand in hand.

Yes, sometimes, alternative investments can meet or even exceed their lofty expectations. But that’s usually because, with any investment, if you take on exceptional risk, you can win big… or lose big all in the same way. Besides, if you concentrate too much into high-risk ventures (which is often the case if you read the alternative investment fine print), that’s not really investing; it’s speculating – like playing at the high-stakes table at the casino. If you do have excess cash to ante up, be my guest. But recognize the wager for what it is and allocate accordingly.

See, the rich are different from you and me — they blow their money on hedge funds, instead of lottery tickets. – Matthew O’Brien, The Atlantic

Costs (still) matter. A lot.

Your alternative adventures are further diminished by every penny it costs you to play. And make no mistake: Those costs are often steep. “Hedge fund math: Heads we win, tails you lose,” describes the usual hedge fund “2-and-20” pricing structure, which translates to 2% annual fees, PLUS 20% fees on certain gains. Compare that to the simple 0.5% (or less) fees for a sturdy index fund and you’ll conclude, as financial author Larry Swedroe has:

Hedge Funds are not Investment Vehicles, they are Compensation Schemes – Larry Swedroe, Seeking Alpha

It (still) pays to read the fine print.

When an investment is “alternative,” it may or may not be subject to the same strict disclosure and performance reporting required by mainstream investments. Often, what to disclose and how (or even whether) to report on performance is left up to the product provider.

What will the all-in costs be? What are the investment’s specific goals and objectives? How hard will it be to get your money back out when you want to? How is the investment performing compared to an appropriate, risk-adjusted benchmark? Is it using “short” and/or “put” strategies to further leverage your dollars (which can also exponentially increase the size of your risky “bet”)?

As an “accredited investor” (so the theory goes), you’re supposed to be able sort out these questions for yourself. All I can say is, good luck. In contrast, you won’t have to look very hard to find ample evidence suggesting that, after costs, alternative investments are more likely to pay off for the product provider than for you. This Motley Fool piece, “Two Hedge Fund Managers Walk Into a Bar…” is tongue in cheek, but there is much truth behind the humor.

Most alternatives are actually an alternative to retirement in my experience. – Reformed Broker Josh Brown

Bottom line? Whenever people bring me alternative investments to assess, here’s what I usually find: Increased costs, additional risks, unnecessary complexities, opaque arrangements and lower expected returns. It may not be as exciting to brag about, but for my money, evidence-based investing remains the best way I know of to not only build wealth, but to hang on to it too.