Suitability

Limited partnerships

The suitability of a limited partnership can vary depending on its business, setup, and structure. For example, you may recall learning about oil & gas programs if you’ve previously prepared for the Series 7*, where the risk and benefit profile of each is unique. Regardless, there are a few common traits that apply to most direct participation programs.

*The specifics of oil and gas programs are unlikely to be tested on the Series 66.

Liquidity risk applies, especially to non-public limited partnerships. Investing in a limited partnership requires a lengthy process and a subscription agreement. Getting out of a limited partnership can require the approval of the general partners and/or finding a suitable investor as a replacement. You don’t need to know the specifics, but cashing out of a limited partnership is not nearly as easy as selling stocks or bonds.

The pass through of losses is another staple of direct participation programs. While losing money isn’t fun, the ability to get a tax write-off due to business expenses or losses is not something afforded to other investments. For example, the only way to obtain a tax benefit from a stock investment is to sell it at a loss, which creates a potentially deductible capital loss. With a limited partnership, losses can be attained and used for deductions without selling the investment, which is a big advantage.

Beyond liquidity risk and pass through of losses, DPPs can offer a variety of risks and benefits. Investors should always do enough research to understand the business and the risks it presents. Even if a DPP seems low-risk, liquidity risk and pass through of losses make them especially suitable for wealthy investors seeking tax benefits. Regardless, investors should not seek out DPP investments purely for tax benefits. If the business is not successful at some point, the investor can lose large amounts of money. Tax benefits only go so far!

Limited partners are only liable for losing their basis (amount contributed). The higher the basis, the more money is at risk.

Hedge funds

Hedge fund investments provide two primary benefits - capital appreciation and diversification.

Like any other fund, shareholders benefit when the value of the fund’s assets increases overall. The ultimate goal is to attain capital appreciation by redeeming shares at a higher value than the original cost. For example, an investor places $1 million in a hedge fund, then redeems their investment ten years later for $5 million.

Hedge funds also provide unique opportunities for added diversification. As discussed above, many hedge fund investments are unusual and typically unavailable to smaller investors. Exposure to these “exotic” investments allows an investor to diversify beyond simple stock and bond allocations.

Like any other pooled investment, most risks imposed on shareholders are tied to the fund’s assets. For example, a fund with a significant allocation in debt securities would likely be subject to high levels of interest rate risk. Hedge funds often invest in more speculative and aggressive investments, but risks vary because each fund is managed differently. Generally speaking, hedge fund investors are subject to capital risk, which occurs when an investor loses part or all of their original investment.

Hedge funds are also subject to risks that other pooled investments generally avoid. For example, hedge funds have considerable liquidity risk. Most maintain lock-up periods that do not allow their investors to request withdrawals for lengthy periods. For example, some hedge funds only allow redemptions at the year’s end. This structure enables portfolio managers to invest fund assets without worrying about keeping cash available for redemptions.

Legislative risk also applies to hedge fund investments. Politicians and regulators have threatened to write rules governing hedge funds for years. New laws would likely result in rising administrative and legal costs if this were to occur.

Hedge fund investors are generally wealthy and sophisticated due to regulatory requirements. To avoid regulation, hedge funds typically only offer investments to accredited investors. This type of investor is also suitable for the high-risk, high-return potential investments held in the fund’s portfolio.

Smaller investors with less market experience may be suitable for investments in funds of hedge funds. These investments diversify across many different hedge funds and maintain shorter lock-up periods (some have no lock-up period). Regardless, a fund of hedge funds is still considered an aggressive investment with high risk and return potential.

Structured products

Investors in structured products must be tolerant of certain risks and complexities related to these financial instruments. As we discussed in the previous chapter, structured products are subject to credit (default) risk (on the debt component) and liquidity risk (except for ETNs). Therefore, investors in need of liquid cash and/or concerned about losing money due to default should avoid these securities.

Structured products tend to be complex and difficult to understand. Most retail investors have little-to-no knowledge of derivatives or debt securities, much less a product that combines the two. Due to their lack of simplicity, only sophisticated or institutional investors with broad knowledge of securities should consider these products.