Home>Alternative Investments>How to Invest in Alternatives Part I: The Investment Structure
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How to Invest in Alternatives Part I: The Investment Structure

When considering alternative investments, consider the investment eligibility of the client. Private offerings, such as hedge funds and private equity funds, require that investors be accredited (generally $1 million net worth exclusive of one's residence) and/or have qualified client status (generally $1.5 million net worth). Some funds are available only to qualified purchasers, entities with $5 million in investments. Public alternative offerings, such as mutual funds, have no such wealth requirements, but may have large investment minimums designed to force an individual to invest through an advisor.
One must also consider the client's liquidity needs. Private offerings often have initial lock-ups and infrequent redemption periods (typically one year and quarterly, respectively, for hedge funds) as well as high investment minimums (typically $1 million for single manager funds and $100,000 for funds of funds), which may tie up a large portion of the client's net worth. Additionally, some private offerings may institute redemption gates, which can indefinitely suspend redemptions.
Before investing in unregulated offerings, particularly from unregistered firms, investors should dedicate a significant amount of time to due diligence. Potential investors should understand management's criminal, regulatory, and investment background; the firm's technological, trading, and backoffice resources; and the administration, custody, and audit functions of the firm. Investment advisor registration and registration under the Investment Company Act of 1940 will alleviate many of these duties.
Taxes are always an important consideration related to any investment. Alternative mutual funds are typically taxed as other mutual funds--on both fund distributions (dividend and capital gains distributions, taxed at ordinary income and long-term capital gains rates, respectively) and share sales (long-term or short-term capital gains) if held outside of tax-deferred accounts. Unlike traditional mutual funds, however, alternative mutual funds tend to trade more frequently, and therefore may incur higher tax liabilities.

Mutual fund generally pass-through the net tax characteristics of their underlying investments, but there is an exception with commodity futures and options. These contracts are taxed at ordinary income rates.

Like mutual funds, hedge funds are also generally taxed as pass-though entities, but hedge fund investors file schedule K-1, rather than a 1099-DIV.

In terms of fees, mutual funds do not charge performance fees, while hedge funds and private equity funds do. Most alternative investments charge some sort of management fee. A mutual fund expense ratio calculation includes management fees as well as other operational expenses. Expense ratios for alternative mutual funds tend to be higher than for traditional mutual funds, typically 1.5% or more.

See the Alternative Investment Structure Matrix for a summary of these issues.

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