Investors seeking greater portfolio diversification are increasingly moving into alternative investment funds.

One feature that makes investments described as alternative different from those considered traditional is — in most cases — the degree to which an investor is directly exposed to the success or failure of a specific undertaking.

Alternative mutual funds

An investment in an alternative mutual fund, or liquid alt, means putting capital to work in a non-traditional way since the fund invests using hedge fund strategies or attempts to reproduce hedge fund returns. But, unlike most direct investing programs, a liquid alt shares many features with conventional mutual funds.

Among other things, they must comply with SEC regulations that require transparency, disclosure, and daily calculation of net asset value (NAV). They can’t charge performance fees and must limit their use of leverage and illiquid investments. A primary advantage is that liquid alts require a much smaller upfront investment than a hedge fund. But the fees a liquid alt charges, while much less than those of a hedge fund, are substantially higher than the fees on traditional funds with no guarantee of a higher return.

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Energy investment funds

Alternative energy funds raise money to invest directly in exploring and drilling for oil or natural gas. The program buys or leases the land under which its sponsor or management team believes hydrocarbons can be extracted profitably. Also, it secures the necessary permits and installs the equipment required to drill wells, pumps the oil or gas to the surface, and arranges for its transportation to storage and refining facilities. If the venture is successful, the program provides income over the productive life of the well or wells. If it’s not, for whatever reason, the program yields a loss.

Energy programs are generally structured as limited partnerships, with one or more general partners and a number of limited partners. So, the general partner is responsible for running the project and is personally liable for its potential losses. The limited partners provide investment capital, which they could lose, but have no control over the decisions the partnership makes and no responsibility for any debts it may incur.

Partners in an energy program may enjoy a number of tax benefits, including deductions for intangible drilling costs (IDC), a depreciation allowance for the tangible drilling costs, and a depletion allowance. All these can reduce taxable investment income. However, while general partners may take these deductions and allowances against ordinary income, limited partners may take them only against passive income.

And the rules are complicated, so claiming these benefits requires the advice of a tax professional. While there may be significant profits from successful energy programs, there are also significant risks. Those include, among others, production risks, operational costs, fluctuations in market price, and the consequences of potential spills or other adverse affects on the environment.

Life settlements

In a life settlement, the owner of a life insurance policy sells it for more than the cash settlement value he or she would receive for surrendering the policy but less than the face value that the beneficiary would receive at the insured’s death. The policy owner and the insured may or may not be the same person.

The third-party purchaser is typically a company known as a life settlement originator or provider. The firm works with life settlement brokers to identify policies to buy and sell either individual policies or interests in its portfolios of policies to investors. Some but not all originators are licensed or regulated by the state where they operate. Investors make a cash payment and pay their share of the ongoing premiums that keep the underlying policies in force and the administrative costs of keeping track of the insured person’s condition, obtaining death certificates, and valuing the policies.

The investment return on a life settlement is a pro-rated share of the death benefits when the insured parties die. The risk is that more time will pass before the deaths occur than investors were led to expect. This increases the amount that must be paid in premiums but not the death benefit. There’s also a risk the insurance company that issued the policy will refuse to pay the death benefit or that the insured’s heirs will challenge the sale.

Equipment leasing fund

From the carriages and the horses that pulled them in the 1700s to the railroad cars and the engines that powered them in the late 1800s, leased equipment has been an integral part of US business. Today’s equipment leasing programs, with their third-party investors, evolved gradually as a way for businesses to secure necessary equipment without huge capital outlays or being saddled with obsolete property.

Equipment leasing programs offer businesses an alternative to purchasing hard assets that may be extremely expensive, likely to become obsolete quickly, or both. The programs raise capital to purchase the equipment from investors who expect to receive a steady stream of income as a pass-through from the payments the lessees, or equipment users, make.

The contracts that govern these arrangements specify the lease term, the recurring payment, and termination provisions, which may include returning the asset in good condition, the option to renew at a favorable rate, or the right to buy the equipment.

In addition to regular income, participating in leasing programs may be attractive for the potential tax benefits, specifically, accelerated depreciation of an investor’s share of the cost of the equipment. Also, equipment leasing programs can serve as a hedge against both inflation and recession, and when interest rates are low, be an attractive substitute for conventional fixed-income investments.

However, there are risks that may reduce cash flow or put capital at risk. While equipment can be reclaimed in default, the process can be protracted and costly. Outdated or damaged equipment can be difficult to release or sell. And, in the absence of a secondary market, an investment in a leasing program is generally illiquid.

Common Alternative Investments Funds and Examples by Inna Rosputnia

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