Good questions are every investor’s best defense.
Between now and 2030, financial advisers will move some $2 trillion of their clients’ money into alternative funds, consulting firm Cerulli Associates estimates.
Whether that will work out well for you depends on whether you ask the right questions. This column will get you started.
The problem is simple but urgent: Most financial advisers have limited experience or expertise in analyzing private equity, hedge funds, nontraded real estate, private credit and other alternative assets.
And detailed analysis is mandatory. Private funds can carry hefty, highly variable, often bewildering fees. Their marketing and disclosures can be murky. They value their assets infrequently, in the shadows, rather than in the daily sunlight of public markets—and even insiders concede those valuations can be dubious.
These funds let you buy at will, but you may need to hold for years on end—and generally can sell only limited amounts at predetermined times. They can complicate your taxes and estate planning.
Why, then, are many financial advisers pushing them?
Some private funds have provided outstanding performance and valuable diversification. Alternative assets helped Yale University’s endowment, led by the late David Swensen, earn stellar returns for decades.
But alternative-fund managers are hankering to sell to individual investors, and many financial advisers are seeking to justify their own fees by offering access.
That’s why you need questions that won’t prevent you from buying a good private fund from a competent adviser—but will screen out unattractive funds and unqualified advisers.
Start with these questions from Mark Higgins, a financial adviser at IFA Institutional and author of the book “Investing in U.S. Financial History.”
I’ve read several articles that are skeptical about whether the returns on alternative funds will justify the costs, risks and reduced liquidity. Describe such critiques to me in detail, without judging them. What evidence would you need to see to tell me not to invest in these funds?
History shows that individual investors are targeted toward the end of financial booms, not the beginning. Trillions of dollars in institutional capital have poured into alternative assets since the 1980s. Why do you believe this is near the beginning, not near the end?
Charles Ellis, who served on Yale’s investment committee while Swensen ran its endowment, points out that “the very best managers have one great power: the power to decide who gets invited to invest in their funds.” They naturally prefer institutions that can make repeated large investments and hold for decades. Ellis suggests asking:
Why do you think this manager is inviting me in? Might that be only because the best investors wouldn’t invest?
Kimberly Flynn, president of XA Investments in Chicago, advises asking:
If the manager built its track record on a small asset base, why do you believe it can continue to perform well as it gets bigger? How much money can this strategy absorb without jeopardizing future returns?
If a fund offers high income, Leyla Kunimoto, a private investor who edits Accredited Investor Insights, asks:
The distribution yield looks attractive, but what percentage of it is covered by cash net investment income? If the fund pays distributions from sources other than net investment income, identify them and their contribution.
A WSJ reader, Patrick Lawler, offers:
How tax-efficient is this fund relative to the most similar exchange-traded fund? For tax reporting, does it use Form 1099 or the dreaded K-1 form?
Another reader, who recently read a prospectus stating that any disputes must be settled under Bermuda law, asks:
If anything goes badly wrong, what recourse do I have against the fund manager—and where?
Here are more questions from me:
Exactly what limits and fees apply if I need my money back sooner than expected?
Institutional investors have experience and expertise in selecting and monitoring alternative investments. Even so, their performance has often faltered, and some are having second thoughts about holding these assets. What in your track record shows that you can reliably identify superior private funds even though institutions often can’t?
Private-equity funds are sitting on more than 13,500 U.S. companies they can’t sell. Why should I buy?
Many ETFs charge annual expenses below 0.05%. Alternative funds often charge at least 2%, sometimes much more. Please provide an itemized list of all costs I will incur, including underlying fund fees and expenses. Why do you think it’s a good idea for me to pay fees so much higher than an ETF’s?
For much of the past 20 years, alternative managers could leverage returns with borrowed money at remarkably low rates. Now that interest rates are higher, why won’t future returns be lower?
How sure are you that this fund’s valuations of its assets will turn out to be accurate even in a market disruption? Explain your reasoning.
Do you or your firm earn any extra compensation for recommending this fund? Does an alternative-fund manager have an ownership interest in your firm, and does it benefit from this recommendation?
Finally, get personal, advises Michael Zeuner of WE Family Offices:
Based on everything you know about my current and projected net assets and income, what specific factors make you think I can put this money aside for 10 years or more without impairing my daily financial life? What gives you confidence that I won’t want—or need—to bail out, even at a significant discount?
As soon as this column is published, private-fund managers will start working on feel-good scripts that advisers can recite to reassure clients.
That’s why you should insist that your adviser answers these questions in writing. Bookmark or screenshot this column to keep the questions handy. You’re going to need them.
Write to Jason Zweig at jason.zweig@wsj.com