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Five red flags for alternative investors

Do you know what you're getting into when you choose hedge funds, commodities and managed futures over stocks, bonds and cash?

Jess Morgan 11 August, 2015 | 5:00PM
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Jess Chapman: For Morningstar.ca, I'm Jess Chapman. You've heard a lot about alternative investing – moving away from the standard portfolio of stocks, bonds and cash toward hedge funds, commodities and managed futures – but you may not know what to ask before you buy. We're joined by consultant and author Steven G. Kelman.

Steven, alternative investing is very unique because oftentimes these products are promoted as any retail product might be instead of by traditional financial institutions.

Steven G. Kelman: You are absolutely correct. There are what are called exempt market issues out there, which means that the issuers are exempt from offering them under prospectus, or rather use an offering memorandum. And originally these were available only to institutions that really have the staff on hand to analyze these.

Chapman: So let's start with the first of the five red flags that you've identified for alternative investors, and number one is unrealistic promised rates of return.

Kelman: If somebody is offering you a rate of return far above what you would pay to borrow money from a bank, be cynical and ask yourself, “Why are they coming to me? Why aren’t the banks doing this?”

Chapman: Let's move on to red flag number two: The promises in the promotional material are absent from the offering documents.

Kelman: I looked at a document that goes back seven years ago, where they were advertising that the money that they would take from you would be invested in a portfolio of companies with A credit ratings. The offering memorandum said that the money was going to be loaned to an affiliated company and it was unsecured and the affiliated company would lend it to for any number of purposes, entirely different than what the advertising said, and that, when that company went under, multi-million dollar losses for its investors. It was predictable.

Chapman: Next we have red flag number three: The issuers' business objectives don’t many any sense.

Kelman: You look at something, you want to know what are they trying to do. How are they going to do it? If they are going to convert something into a hotel or build some massive condo and they don’t really own the land yet or this still has to be resolved and everything, you start wondering, how are they going to get this done?

Chapman: On to red flag number four: The promoters' objectives are way out of step with the objectives of the investor.

Kelman: What you look at is how the promoter is going to get paid and how you are going to get paid. So if the promoter takes your money and gets paid upfront, you are going to wonder, well, how am I going to get money out of that? Does the promoter have enough money to do what he or she says is going to be done?

Chapman: Finally, I think this is the biggest one, red flag number five: The promoter is in poor standing with regulators.

Kelman: Well, go back a step on that. First thing you want to do is to find out if they are registered with any regulatory body, be it securities or insurance because their investment products that have insurance. All the regulators have lists of people that have been disciplined and you want to look that up. The leopard may not change its spots. In some cases, you can see that somebody has been fined for horrific behavior. In other cases, it might just be they made a phone call out of the province. But you look at that and you can make a decision on that. But you want to make sure that they are registered to start off with and the product is something that they can sell.

Chapman: Steven, thanks very much for these guidelines.

Kelman: You are most welcome.

Chapman: Visit Morningstar.ca for your investment news and updates.

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About Author

Jess Morgan

Jess Morgan  Jess Morgan is the associate editor of Morningstar Canada’s website. She began her career as a television producer and freelance writer, often making appearances on TV and radio as a commentator on politics and culture. She holds a BA in communications from the University of Winnipeg and a diploma in Creative Communications from Red River College.

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