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Even Affluent Don't Fully Understand Alternative Investments

Most alternative investment products are neither well-understood nor on the shopping lists of affluent investors with $500,000 or more investable assets. Moreover, fewer than one-third discuss including alternative investments in their portfolios with financial advisers.

This is according to a survey of 514 affluent investors conducted in late 2006 by Spectrem Group of Chicago and released last week. The poll included questions about hedge funds, real estate investment trusts, commodities, private equities, venture capital and structured products, the latter being any number of synthetically created equity or fixed-income instruments. It is Spectrem's first in-depth research about affluent investors focused exclusively on alternative investments.

"I thought going in that people would not understand these products, which they don't. But what surprised me is that there isn't more interest in these products," said Tom Wynn, director of the Spectrem Group. "People need to be educated about alternative investments."

Of those polled, 82% said that they didn't understand hedge funds, 40% admitted to not comprehending private equities, and a full 50% didn't grasp structured products. Seventy-two percent of those surveyed said they had no interest in investing in hedge funds, and 61% said they'd prefer to stick to traditional products traded on an exchange.

Additionally, 33% said their main reason for not investing in alternative investments was that they are too risky, while 25% indicated they didn't have enough knowledge about them.

"Lack of understanding is a primary reason for a lack of interest in these products," the survey concluded. Greater wealth and income generally correlated with a greater understanding of and interest in the products, the survey also found.

On the perception risk meter, hedge funds were judged by respondents as the riskiest choice, with commodities coming in second and private equities and REITs judged to be the least risky of the lot.

"These products are so equated with being risky, particularly hedge funds," but can actually lower an investor's risk by broadening the types of securities in which they are invested, Wynn said.

In releasing the survey results, Spectrem reminded firms offering alternative investments that such products are sold and not bought. Financial companies must push these products for them to be successful. Spectrem also suggested developing alternative products for the lower affluent population and younger investors.

In addition, financial companies that don't want to manufacture these investment products themselves should partner with companies that do, the firm advised.

Although structured products have yet to be well understood by many investors, they are elbowing their way into the repertoire of investment management products that firms are offering.

This past October, for instance, DWS Scudder of New York, the asset management division of Deutsche Bank, announced it had hired two executives, both formerly of ABN-AMRO, to spearhead the new structured products team in the U.S. that will sell these products along with mutual funds.

Two weeks ago, Nuveen Investments of Chicago announced that it had formed a division that will create new structured products and make them available along with closed-end funds with the goal of enhancing investors' portfolio diversification and need for income-producing investment solutions.

"The structured products industry in the U.S. is still in its infancy," said Chris Warren, head of structured products for the U.S. at DWS Scudder. Past attempts by firms and banks to make inroads with structured products were not very successful, and many firms still keep them tucked away within their investment banking business, he said. Most firms did an excellent job of innovating good products but a poor job of marketing them and educating the investing public about them, he added.

"You are seeing the beginning of a paradigm shift of structured products in the U.S.," Warren predicted. Instead of seeing them as a new asset class, they will be seen as part of the financial toolkit with, eventually, the lines blurring between mutual funds, exchange-traded funds and structured products, he said.

In order to educate the end investor about these products, there will need to be a "trickle-down education" effort, he noted. Manufacturers will need to get their structured product staff up to speed. They will, in turn educate wholesalers, who will educate financial intermediaries and registered investment advisers, who will then help investors understand their uses and benefits.

DWS Scudder is currently focusing on educating its own wholesalers about structured notes. "We're looking at using the 40 Act technology platform to include structured products," Warren hinted.

(c) 2007 Money Management Executive and SourceMedia, Inc. All Rights Reserved.