The suitability of a limited partnership depends on the partnership’s business, how it’s set up, and how it’s structured. For example, you may recall oil & gas programs from Series 7 preparation*, where each program can have a different mix of risks and potential benefits. Even so, most direct participation programs (DPPs) share a few common traits.
*The specifics of oil and gas programs are unlikely to be tested on the Series 66.
Liquidity risk is a key concern, especially for non-public limited partnerships. Buying into a limited partnership typically involves a lengthy process and a subscription agreement. Exiting can be difficult because it may require approval from the general partners and/or finding a suitable replacement investor. The main point is that cashing out of a limited partnership is usually much harder than selling stocks or bonds.
Another common feature of DPPs is the pass-through of losses. Losses can create tax deductions tied to business expenses or operating losses - something many other investments don’t provide in the same way. For example, with a stock investment, the typical way to obtain a tax benefit from a loss is to sell the stock at a loss, creating a potentially deductible capital loss. With a limited partnership, losses may be passed through and used for deductions without selling the investment.
Beyond liquidity risk and pass-through losses, DPPs can have a wide range of risk and benefit profiles. Investors should research the underlying business and understand the risks it presents. Even when a DPP appears relatively low-risk, the combination of liquidity risk and pass-through losses often makes these investments most suitable for wealthy investors seeking tax benefits.
At the same time, investors shouldn’t choose DPPs purely for tax benefits. If the business performs poorly, the investor can lose substantial amounts of money. Tax benefits can help, but they don’t eliminate investment risk.
Limited partners are generally liable only up to their basis (the amount contributed). The higher the basis, the more money is at risk.
Hedge fund investments are typically used for two main purposes: capital appreciation and diversification.
Like other funds, investors benefit when the value of the fund’s holdings rises. The goal is capital appreciation - redeeming shares at a higher value than the original investment. For example, an investor places $1 million in a hedge fund and redeems the investment ten years later for $5 million.
Hedge funds can also add diversification. Many hedge funds invest in strategies or asset types that are unusual and often unavailable to smaller investors. Exposure to these “exotic” investments can diversify a portfolio beyond basic stock and bond allocations.
As with other pooled investments, many risks to investors come from the fund’s underlying assets. For example, a fund with a large allocation to debt securities may have significant interest rate risk. Hedge funds often use more speculative or aggressive strategies, but the risk level varies by fund and manager. In general, hedge fund investors face capital risk, meaning they could lose some or all of their original investment.
Hedge funds also have risks that many other pooled investments try to minimize. A major one is liquidity risk. Many hedge funds impose lock-up periods that prevent investors from withdrawing for extended periods. For example, some funds allow redemptions only at year-end. This structure lets the manager invest without needing to hold large cash reserves for redemptions.
Legislative risk can also apply. Policymakers and regulators have discussed increased hedge fund regulation for years. If new rules are adopted, administrative and legal costs would likely rise.
Because of regulatory requirements, hedge fund investors are typically wealthy and sophisticated. To avoid certain regulation, hedge funds commonly limit participation to accredited investors. These investors are also generally better suited to the high-risk, high-return potential strategies found in many hedge fund portfolios.
Smaller investors with less market experience may be more suitable for funds of hedge funds. These products spread investments across multiple hedge funds and may have shorter lock-up periods (some have no lock-up period). Even so, a fund of hedge funds is still considered an aggressive investment with high risk and return potential.
Investors in structured products need to be comfortable with both the risks and the complexity of these instruments. As discussed in the previous chapter, structured products are subject to credit (default) risk (on the debt component) and liquidity risk (except for ETNs). That means investors who need ready access to cash and/or are concerned about losses from issuer default should generally avoid these securities.
Structured products can be difficult to understand because they often combine debt securities and derivatives. Most retail investors have limited familiarity with derivatives or debt securities, and structured products add another layer of complexity. Because of this, these products are generally most appropriate for sophisticated or institutional investors with broad knowledge of securities.
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