Individual Bonds — in addition to all the reasons listed for individual stocks (low diversification, high costs, etc.), individual bonds can have liquidity issues, meaning they can be difficult to sell quickly without having to drastically reduce the price.
Futures Contracts — Futures contracts are legal obligations that require the buyer to purchase an underlying asset (or the seller to sell that asset) at a predetermined future price and date, regardless of the market price at the future expiration date. Trading futures is a zero sum game. If there is a winner, there is also a loser. Futures contracts typically offer between 10x and 50x leverage, which means a $1 per contract loss can become a $10 - $50 loss. Finally, futures can “go below zero”. At the extreme, the price on a contract can drop to the point you must pay to get rid of it.
Option Contracts — Options are contracts that give you the right, but not the obligation, to buy or sell a security (compared to a futures contract which requires the purchase or sale of an asset at a future date). You pay a premium to use them and can be the source of speculation, adding a layer of risk to their use. Navigating the various types of option contracts requires complex administration, adding more overhead cost to their use. We do employ certain option contracts in a limited capacity when disposing of an incoming concentrated position.
Private Placement in REITs — A real estate investment trust (REIT) is a company that owns and operates various real estate properties in which the majority of its income is paid to its shareholders as dividends. There are publicly traded REITs we use as part of our diversified portfolio. Private placement REITs are not listed on a major exchange and subject very loose SEC regulatory requirements. The lack of regulatory scrutiny creates a great deal of managerial risk. Because of this, many private REITs are only accessible to accredited investors (those determined to be financially sophisticated based on income and net worth requirements) making the cost of entry extremely high. Finally, many REITs charge high commission fees and lack liquidity — with liquidity restrictions varying greatly from fund to fund.
Private Placement in Oil & Gas — Similar to private REITs, private placements in oil and gas are loosely regulated, illiquid, and typically restricted. In a private placement, a company sells shares of unregistered securities to a limited pool of accredited investors in exchange for cash. Private placements in oil and gas are usually administratively complex and highly variable.
Hedge Funds — An expensive substitute to other pooled fund investments, hedge funds are actively managed alternative investments. Hedge funds share many of the downsides of Private Placement REITs: lack of SEC regulation, absence of transparency of the management and performance, accessible only to accredited investors, insufficient liquidity, and an overabundance of risk. Additionally, hedge funds often charge both an expense ratio and a performance fee (typically +20% of any profits) and usually employ leverage (take on debt) to amplify returns. Moreover, certain hedge funds in the past have presented significant moral hazard.
Closed-end Funds — These are portfolios of pooled assets that have an initial public offering (IPO) and sell shares on a stock exchange. It is called a closed-end fund because after it’s IPO, no additional shares are ever issued and the fund won’t ever buy back shares. This causes liquidity issues when trying to dispose of closed-end funds and the funds often trade below net asset value (NAV) at a discount. The price is determined entirely by supply and demand on the secondary market, making the investment vehicle subject to more volatility. Closed-end funds do have niche applications in small marketplaces, but for the general investor there are better options.
Short Selling — This investment strategy relies on speculation around the decline of a stock price. If an investor expects the price of a stock to drop in the future, they can borrow stock shares and immediately sell them on the open market. When they are due to return the borrowed stock, they hope to buy the stock back in the open market for less than they sold it for — making a profit on the price drop. The degree of speculation in this process is high and there is no limit on the amount you can lose (hello GameStop and the nearly $13 billion lost).
