Once you have crossed the hard-earned threshold to be classified as a "high income earner", you will be a prime target for salesmen pushing the latest and greatest exotic investments. Many of these investments are inappropriate for a large portion of the population, especially for those who have not covered the basics of saving and investing for retirement. Some people are lured into an inappropriate investment because they assume that this is the way "wealthy" people do it. Here are some of the complicated investment products often sold to high net worth individuals, and what to watch out for in each case.
Separately managed accounts. These accounts are set up to be professionally managed, and the manager has the authority to buy specific investments for the account. Instead of owning a pooled basket of holdings like a mutual fund, the investor will directly own the investments in the account. Separately managed accounts are customizable, because the manager can buy different investments in each account. And since assets are not pooled you will not receive taxable distributions from previously pooled transactions like you would in a mutual fund. Taxable income is only generated when the manager places trades that result in a gain or the portfolio holdings issue interest or dividends.
The catch: SMAs have minimum balances (most around $100,000), so it is hard to build a well-diversified portfolio without having substantial assets. It is much easier to build diversification with mutual funds and exchange-traded funds. It is not uncommon for a SMA to purchase many small holdings, which can make these accounts difficult to monitor. You might have tiny share ownership in 60 different companies with some as small as five shares. You will receive annual shareholder reports, proxies and legal disclosures from each investment, so just keeping up with the amount of mail or email you are receiving could be a chore. Index mutual funds and ETFs are also tax efficient investments and are typically significantly cheaper than SMAs.
Hedge and venture capital funds or private real estate. Success often leads to opportunities for private deals, and there is an entire industry set up to persuade you on why your money should be invested there. While there are opportunities in this space, this type of investment is at the top of the risk scale and only appropriate for a small percentage of the population. These investments have so much risk that the government requires investors to prove that they are sophisticated or wealthy enough to absorb the uncertainty with the accredited investor requirement. To be considered an accredited investor in the U.S. you must have a net worth of at least one million U.S. dollars, excluding the value of your primary residence, or have an income of at least $200,000 each year for the last two years (or $300,000 combined income if married) and have the expectation to make the same amount this year.
Private equity, real estate, hedge funds and venture capital all market their exclusivity. While anyone can buy a publicly traded stock, these investments are often not available to the public. The wealthiest investors in the world are often associated with these private deals.
The catch: Private investments are often illiquid. Once you join the club, you have lost the ability to vote with your feet. If you do decide to leave a private investment you must work with management's timeline and process for dissolving your interest.
Make sure you understand all the fees involved in the investment. Hedge funds often charge a "two and 20" fee structure. Managers charge a 2 percent annual management fee on assets and an additional 20 percent on profits and gains. Private real estate deals will also have annual management fees. Since these private holdings are not as regulated as the public marketplace, it is on the individual investor to understand what is a fair and reasonable fee.
Forget about filing your taxes by April 15. Assuming you are investing in these deals with after-tax money, you will likely not receive a 1099 like you would with your traditional brokerage account. Instead, you will receive a K-1 tax form. It is not uncommon that you will not receive your annual K-1 until a month or two after the initial April 15 filing deadline. Extending your tax return will become an annual tradition. Unlike the quarterly statements you might receive for brokerage accounts held at major institutions like Fidelity, Vanguard or Charles Schwab, receiving information on private investments (and having them properly valued) is a more arduous task.
When you wade into the world of private and complex investments, you will want to double down on education efforts to ensure you understand what you are doing with your investment capital. Here are a few questions to ask yourself when offered these types of investments:
-- Do you have the financial basics covered, including emergency reserves, saving 15 to 20 percent of your income for retirement and paying off debt?
-- Do you understand what this product or fund invests in and how it works?
-- Does this investment fit into your long-term goals and objectives?
-- How much does the management team of the investment have invested, and how does this compare to their net worth?
-- Does the management team of the investment have any of their relatives in this opportunity?
If you do not feel comfortable with an investment or do not have the desire or aptitude to learn about it, then it may be wise to avoid these types of investments. It also makes sense to have a clear understanding of your long-term goals and how these types of investments will help you reach your objectives. The sizzle and excitement of an exclusive investment will not guarantee the financial gains you are looking for.
Brian Preston and Bo Hanson are fee-only financial planners who host the podcast, "The Money-Guy Show".
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