Wealth, Actually

by Frazer Rice

  Due to these risk factors, investors look for fund managers with proven track records in private equity and venture capital. They may be managers who are skilled at identifying exit strategies for businesses or who provide you with access to good deals in the market. Good fund managers are often able to give you the first look at investment opportunities, because they are experienced and have a strong network of contacts.

  Hedge Funds

  Hedge funds have evolved and now can include many types of investments. A hedge fund is similar to private equity in that the manager has discretion in their investing and receives a higher management fee than they would earn by managing mutual funds or ETFs. The hedge fund world has been described as a management compensation scheme as much as a methodology of investment, but managers do generally take active and concentrated bets in various parts of the market to create returns that they hope will outperform traditional markets.

  These managers’ tools can include using leverage to create outsized singular bets, or they might bet against the market. By cutting across different asset classes, they can take advantage of market discrepancies that they spot. A hedge fund can own stocks, bonds, gold, bitcoin, private equity, venture capital, and effectively any other type of asset.

  Hedge funds carry a much broader mandate than private equity or venture capital funds. Hedge funds are actively managed investment vehicles that incorporate a variety of tools and asset classes with the goal of outperforming traditional stock markets.

  As for liquidity, you do not typically have ready access to your investment. Hedge funds normally require a quarter’s notice to redeem your money, and it could take more than a year to actually receive all of it. Hedge funds justify the illiquidity by saying they are invested in positions for a long time and if everyone could redeem their investments, it would create difficulty in the portfolio by forcing quick sales at inopportune times. Hedge funds are not particularly transparent, although this benefits them, because it allows them to cloak their investment positions and strategies. The edge that most hedge fund managers have is their access to information.

  Finally, a yield is generally not generated by hedge funds. They’re usually charging a management fee and a performance fee that is tied to the size of the assets, so paying out a yield to investors regularly is antithetical to how the fund managers make money. They try to buy low and sell high and invest any profits and proceeds in other ideas toward further growth.

  Hedge Fund Risks

  The risks are most prominent from a liquidity standpoint, because you won’t likely have ready access to your investment. Functionally speaking, when you get your assets back from a hedge fund, you might get 90 percent of your assets back, with 10 percent held back pending a final accounting. Getting back all of your money could take upward of a year. Additionally, you may be invested in esoteric securities and strategies that are difficult for the managers to explain.

  Things can get turned upside down quickly. Managers may borrow money to make bigger bets and fuel a higher rate of return. If they’re wrong, that type of leveraged bet can also tank a portfolio and render it unable to perform to your expectations.

  An additional risk to your investment returns can arise from the high fees received by hedge fund managers. Even if they do a decent job, you may not benefit as expected after you pay the manager a management fee plus a performance fee. Many funds may be benefiting the hedge fund managers more than their investors. It’s extremely important to understand what you’re paying for and also to measure your investment success on an after-tax, after-fee, after-inflation basis. After all the fees charged within a hedge fund, you may find you’re better off investing in a lower-cost ETF. Especially in the last five years, many hedge funds have been unable to outperform ETFs after hedge fund fees and taxes are taken into account.

  Regarding taxes, investors may find that even if the returns on their hedge funds are moderate to poor, their tax bills are high. That can be an unpleasant surprise for people who don’t have a lot of experience with hedge funds. Tax obligations are generated because there’s a lot of buying and selling going on within the fund, which in turn can create taxable gains. These investments often make more sense in nontaxable vehicles than in taxable ones.

  Real Estate

  Real estate is usually a long-term investment that is not particularly liquid. You need a willing buyer and a willing seller, a combination that is not always easy to find. The complexities of the selling process multiply as you increase the size and scale of real estate projects. To avoid losses, you need proper banking relationships in place. Should a cash shortfall occur, you need to be able to ride through it. You also need a great exit strategy when you begin.

  Taxes are one of the upsides of real estate investments, largely because of the 1031 Exchange, which can allow you to avoid capital gains tax if you roll the proceeds from a real estate sale into a new real estate project. The tax savings alone can make real estate an excellent investment, although problems can occur when people enter risky or complicated real estate investments for the tax benefits alone.

  Transparency is a big consideration in a real estate investment. There is an industry made up of real estate lawyers, title insurance companies, appraisers, environmental firms, engineering companies, and others designed to ensure that roofs don’t cave in and inspections are passed. You’re only as good as the experts you hire and only as good as the information and representations made on the other side of the transaction. This is why real estate is a trust-and-verify world, and investors should try to gain a deep understanding of location and quality when it comes to deals.

  Yield from real estate ranges within the wide continuum from current cash flow to future growth. A high-rise with multiple rental units that generates monthly income offers much more current income and yield than a Malibu beach house that can only realize a gain from a one-time sale in the distant future. Again, a vacation home is not an investment as much as it is consumption. A speculative piece of personal property is simply not the same as an investment property, which yields ongoing cash flow. People often buy a vacation house without an exit strategy for selling it, which is part of why it should not be considered an investment.

  Risks of Real Estate Investment

  Real estate investments carry multiple risk factors. Being a landlord or developing a project can be extremely capital intensive. There may be inexperience in building or managing real estate projects. You may not capitalize the project adequately, leaving yourself vulnerable if the roof caves in. This is especially at play when you’ve borrowed money to invest in real estate. There are also legal considerations and risks. Landlords and investors may not fully understand their legal obligations, especially regarding tenants.

  Changing demographics and market conditions can be another risk. Characteristics of neighborhoods can change over time, affecting cash flows and rental rates. Often, owning real estate requires improving your property and making sure the community around your property maintains its value as well.

  Owning Real Estate Funds

  Real estate investment trusts (REITs) provide fractional or joint-venture shares, offering a simplified way to invest in real estate. If you want to get involved in real estate without managing it directly, the simplest way and most liquid avenue is through a publicly traded, professionally managed REIT with a diversified portfolio of residential, commercial, and industrial real estate. A REIT may offer a lower rate of return compared to direct real estate ownership, but REITs are an uncomplicated way to get real estate exposure into your investment portfolio.

  Nonpublic REITs or limited partnership real estate investments are available as well and work like private equity funds. You’re still relying on the track record and experience of the manager, which can be difficult to ascertain in real estate. Even if you have the best of managers, economic conditions can sour a real estate investment. Furthermore, to create major retu
rns for investors, managers may borrow money—and that can turn on them if interest rates shift, or if the real estate market doesn’t generate the rent rates or residency demand anticipated.

  Real estate is a long-term investment. Investors are buying a set of rental contracts that are generating income, and a good developer or manager is also trying to increase the value of the property. Publicly traded REITs are usually large and generate a yield, making them a more liquid way to begin in real estate investing. They operate like stocks, but the underlying business is real estate management.

  As you acquire more privately held real estate investments, you can either structure them as a private equity arrangement with access to the managers, or you can own the real estate directly and become a landlord. The latter requires a financial cushion so you can ride the ups and downs of the market. It also requires some property management experience to avoid making silly mistakes and incurring unnecessary liability. If you own and manage your own real estate, you have more transparency, but you also have more work and stress.

  Commodities

  Commodities encompass many different things used in ordinary life and are raw materials like iron and coal, or farm products like oranges or wheat. The value of any given commodity changes over time based on its scarcity and other market conditions. If the housing market is down, for example, there may be less demand for iron or plastics, and the value of those commodities will go down. Orange juice is another common example. If the orange crop is damaged in a freeze and the supply of oranges is reduced, the price of orange juice will rise. If the season’s wheat crop has been bountiful, the price of wheat may drop because there’s more supply than demand.

  There is a whole world of investors who make money from discrepancies in the market. People get involved in commodities to take advantage of those opportunities. They may be Texans who understand how oil production works and where oil demand is headed globally. They may be people in the farmlands who understand wheat, how the food industry works, and where the inputs and outputs go.

  A futures contract surfaces when someone thinks they know the direction a commodity is headed and how the price will be impacted. They would like to buy or sell a commodity at a future point in time for a future price. That’s essentially a futures contract. If you understand weather and thought that the oranges were going to freeze and their price was going way up, you could enter a contract to buy oranges at ten dollars a share in six months. If the real price six months from now is thirty dollars a share, you will have made a big profit.

  If you were the seller and offered to sell oranges at ten dollars a share in six months, but the freeze never happened, and orange prices were five dollars a share, the buyer in the contract with you would still be obligated to buy your oranges at ten dollars a share. You could supply those oranges by buying them at five dollars per share and make a profit of five dollars per share.

  Futures contracts can be far more complicated than these examples, and they can cover everything from coal to gold to pork bellies.

  In terms of liquidity, investments in commodity markets are fairly liquid. However, these markets tend to be volatile, and when the markets are nimble and react quickly, these are not necessarily easy investments. Many times, it’s best to have professional commodities traders execute your trade to protect you from being fleeced on the other side of the contract.

  From a transparency perspective, the markets are quite efficient. You usually have a good sense of prices and access to news on financial networks and websites. It’s the execution where things can get difficult, and you’re usually only as good as the traders you incorporate into your strategy.

  There is no yield. These are strictly investments for future value. These are not buy-and-hold arrangements in which a future contract expires, and you either gain or lose at that time. You can trade the contract before it expires, but you are not receiving a regular yield or income stream from these investments. So, from a yield perspective, they are not particularly effective. They’re volatile and risky, except for the most expert of commodities traders—and even they get rocked occasionally.

  One of the interesting commodities is gold. It has a few industrial uses, such as jewelry. However, many people view gold much the same way they view dollars or yen or euros: as a currency, rather than a commodity. In buying gold, you’re not usually investing with the idea that there’s an industrial use behind it. Rather, you’re buying it because there’s some sort of value accorded to it as a currency, and you want to participate in that.

  Gold is a universally recognized store of wealth, and it’s fairly liquid. It can be bought and sold anywhere in the world. It’s most easily bought within an ETF, which is not direct ownership of the gold but is a good proxy for owning it.

  Gold is also a transparent investment. People know exactly how much it’s worth, what it weighs, and what it can be used for. The major negative for gold is yield, as it does not generate a yield. As a future value investment, you’re hoping that when you eventually sell it, the gold will have a greater value than it has now. Gold also has holding costs, like cash sitting in a bank that’s not earning interest. Additionally, if you store gold at a central safe, you’ll incur storage and trade costs and reduce your overall investment return.

  As a currency, gold holds universal value as a store of wealth. In times of political turmoil or war, gold may be viewed as a stable investment. To grow and preserve your purchasing power over time, however, is an expensive strategy. Gold has historically been used as a buffer against inflation, but studies indicate there are far more effective ways to address inflation, such as income-producing stocks or income-producing real estate.

  Gold may have a place in a portfolio, but I tend to view that place as on the outer edges. Gold had a remarkable run in the 1990s and up into the 2000s, but over the last decade, it has not been a terrific investment. Furthermore, it’s a difficult commodity to predict.

  Collectibles

  A collectible is an item that carries a value greater than the item itself. Examples include art, cars, jewelry, and anything else perceived to have a value that is expected to increase. Collectibles’ value is tied to public admiration or appreciation. With businesses and real estate, you can point to the cash generated to understand its value. With collectibles, however, the value correlates with the popularity of a specific object or artist. Measuring that value is a qualitative exercise that depends on finding the people who appreciate the object and learning how much they’re willing to pay for it.

  The biggest fallacy surrounding collectibles is that they automatically rise in value and are immune to market forces. If the world economy tanks, a Klimt painting that was purchased two years ago for $110 million will not automatically sell for $120 million two years from now. The number of people able to buy that type of asset will likely have shrunk, given the economic collapse.

  Art and collectibles live in a highly specialized, fickle arena. Collectibles are generally sold through an auction process, and unless you have a particularly good broker, the transaction costs are significant and not as transparent as other investments. That being said, some collectibles may be good investments on an after-inflation basis, normally if they are in mint condition and are a scarce commodity.

  Art

  Anybody looking to use art as a store of value needs strong expertise and excellent advisors to ensure they are not defrauded, especially in the way of forgeries. Art is typically acquired through auction houses, and it can be more than just something that hangs on the wall. Often, art will need to be monitored and maintained to prevent it from being damaged by dust or light.

  Art is taxed differently than stocks and bonds. With art, you’ll normally incur local sales and use taxes, and it’s a good idea to be aware of your current tax situation before you go out and buy an expensive art collectible. For people looking at art as an investment, it might make sense to buy it
through the framework of a business entity, such as an LLC. This makes it easier to assimilate the care of the artwork into management of your portfolio, and the shield of a business entity yields the benefit of privacy, which can be beneficial when liquidating the collectible in the future.

  Cars

  When collecting cars, the elements to focus on are exclusivity (the number built), quality, and (if relevant) pedigree. I would also learn if it’s in its original condition or whether it’s been restored. There’s been a lot of talk about restoration as a method of adding value to older cars, and while that may be a good way to move an old clunker, I think it’s more valuable for an investor to acquire a car in its original condition.

  The happiest car collectors I know are the ones who occasionally drive their old Mercedes 300 SL Gullwing. For many, it feels like a shame to have a vehicle like the Mercedes locked up in a warehouse as a pure investment when it was built to be driven. By driving it occasionally, you get the benefit of enjoying its original purpose and turning some heads. That’s not to say you should use that Mercedes to go to the store, because mileage is an issue with the value of this investment.

  When buying a car with an unbelievable pedigree, such as a Ford GT40 that raced at Le Mans, there will be a significant cost for displaying, storing, and maintaining the vehicle. You won’t want to be touching the inside of that car without an extremely competent mechanic. Extremely specialized advice and technical capability is required. Insuring this vehicle can also be expensive.

  Jewelry