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What Are Alternative Investments?
By Peter Burns MONEY RESEARCH COLLECTIVE
Investments beyond traditional securities like stocks and bonds are becoming more common. These non-traditional alternatives to the stock market offer investors a variety of opportunities to maximize profits and diversify portfolios. So what are alternative investments? This article will give you an understanding of alternative investments and how to invest with them.
Table of contents
- Alternative investments defined
- Common types of alternative investments
- How to start investing in alternative assets
- How much of an alternative investment should you make?
- What ratio of alternative and traditional investments is best?
- Deciding if alternative investments are right for you
Alternative investments defined
Alternative investments, sometimes called alts, cover a wide range of assets but do not include conventional investments such as stocks, bonds and cash. Alternative investments are often complex and have a high degree of risk. Additionally, many charge expensive fees and require high minimum investments, so wealthy individuals or institutional investors often hold them.
Some types of alternative investments include:
- Private equity
- Venture capital
- Collectibles
- Commodities
- Hedge funds
- Real estate
Alternative investments can be profitable but often lack liquidity because they aren’t traded on public exchanges.
How alternative investments work
Alternative investments work like most other investments. In the stock market, the best strategy is to invest when stocks are down and then sell them when their value rises. Alternative investments mainly comprise of assets that will appreciate over time. In some cases, like real estate or private credit, you can earn dividends on your investments.
The advantages of alternative investments
Alternative investments come with many benefits for investors. Because the alternative investment market does not correlate with the stock market, you can use alternative investments to protect against the volatility of traditional forms of investments. They also help diversify your assets, and you can even use them to hedge against inflation.
Although alternative investments usually require a higher minimum buy-in and have a greater risk, the payoff can be high. In addition, alternative assets may be subject to pass-through tax deductions or long-term capital gains tax rates.
The disadvantages of alternative investments
There are downsides to alternative investments as well. The profits they can yield come at the expense of higher risk. Some alternative investment funds’ strategies often include speculative approaches like short-selling or using complex derivatives that can cause your portfolio’s performance to plummet just as fast as it can increase your profits.
Alternative assets can also be difficult to value. Your asset’s price may vary depending on who appraises it. Because many alternative investments don’t correlate with the stock market, it can be challenging to calculate the actual value. Alternative investments are also illiquid assets, meaning you cannot sell or trade them like traditional investments. If you need cash quickly because of an unexpected event, it is much easier to sell a stock than a house or a stamp collection.
Common types of alternative investments
Alternative investments are becoming more mainstream. They offer a range of investment opportunities and different risk-return profiles than traditional securities. Although these types of investments come in many forms, you can split them into two main groups: private assets and hedge funds.
Private assets are investments that, in most cases, are not traded or listed publicly. Some examples include private equity, private credit, real estate and collectibles. Alternatively, hedge funds operate in public markets but use non-traditional investment strategies to earn profits.
Real estate
Investing in real estate is buying a house or property to make a profit. Homeowners that purchased their property as a place of residence are real estate investors, as the value of their property may increase over time. You can make profits by investing in real estate in other ways besides selling your property at an increased value. Purchasing a property, renting it out and collecting rent payments are other ways to accumulate profits.
Real estate alternative investments also include Real Estate Investment Trusts (REITs). REITs operate like mutual funds in that several investors pool their money together to make large real estate purchases and gain money over time. Many REITs can be bought and sold like stocks on major securities exchanges. In general, real estate is a good option as a counterbalance against inflation as it has no connection to the stock market.
Private equity
Investing in a private equity fund is a high-risk, high-reward decision. These funds buy private or public companies intending to turn a profit in the future. There are multiple approaches to making money through private equity investing. The private equity fund will assist the company it purchases by infusing capital or changing the business strategies to accelerate its growth. After acquiring a company, private equity firms will manage the business on behalf of the investors, sometimes restructuring the business to make it more efficient and profitable.
Private equity investments may take years to finally pay off. Investors won’t receive any profits until the fund’s stake in the company is liquidated. After years of investment, the initial company may be acquired by another company or, in the case of private companies, be taken public in an initial public offering.
Private credit
Private credit — also called private debt — works when institutional and individual investors combine their funds to become private lenders. Private credit loans are usually given to companies that need the finances to improve and grow. Loans can go towards expansion or acquisitions of other businesses. These loans may also go to companies that need finances quickly, have trouble getting banks to finance them or require non-standard terms.
Private credit includes different types of lending, such as:
- Direct lending
- Distressed debt
- Mezzanine funds
- Specialty financing
Private debt can be an excellent investment, but there’s little liquidity since it depends on the loan’s terms.
Hedge funds
Hedge funds are a collection of private investors’ money invested in multiple ways by hedge fund managers. Hedge fund managers seek to minimize risk and maximize return by utilizing creative investment strategies that benefit all of the fund’s investors. Hedge funds often work by taking advantage of non-traditional securities like currencies, startups, derivatives, interest rates and commodities. These funds are known to be risky and often use speculative strategies that utilize derivatives, debt and other means.
Some common hedge fund strategies include:
- Global macro: Investors benefit from large-scale economic and political events
- Merger arbitrage: Investors benefit from the price differences that occur during a merger
- Fixed-income arbitrage: Investors benefit from the changing praises in fixed-income bonds
- Long-short equity: Investors benefit from a mix of long and short stock positions
- Distressed securities: Investors benefit from purchasing stock in financially struggling companies
Hedge funds often charge very high fees and provide less transparency than other types of investment funds. Before investing in a hedge fund, consider the minimum required investment, financial goals, size, track record and redemption terms. Hedge funds may also have lock-up periods during which investors cannot sell their shares.
Natural commodities
Natural commodities are profitable materials that can be used directly by consumers or indirectly by companies to produce other products. There are many ways to invest in commodities, including buying and selling the raw material directly or investing through futures contracts. These forms of investing are highly complicated and unavailable to the average investor.
You can invest in commodity-related mutual funds or stocks. These mutual funds and stock certificates act similarly to traditional investments, but their values are based on the commodities’ value.
Commodities come in many forms. Some examples of natural commodities include:
- Precious metals
- Livestock
- Farmland
- Lumber
- Oil and natural gas
- Soybeans
- Wheat
- Corn
- Coal
- Sugar
- Coffee
Because commodities can be affected by outside influences such as trade wars, politics and bad weather, these alternative investment assets can sometimes be very volatile. That said, commodities may be a great way to diversify your portfolio and hedge against inflation.
Collectibles
Many people invest in collectibles, sometimes without even realizing it. A middle schooler protecting their autographed Lebron James rookie card is an example of a collectibles investor. A collectible can be any object or possession a buyer will pay more for than the original price. Some examples are:
- Antiques
- Postage stamps
- Coins
- Cars
- Autographed memorabilia
- Sports memorabilia
- Paintings
- NFTs
- Jewelry
- Comic books
- Trading cards
- Rare items
Some collectibles are easier to appraise than others, but online marketplaces like eBay and Amazon have made buying and selling them easier than ever.
How to start investing in alternative assets
Because alternative assets come with a high risk, it’s best to start small and gradually increase your investments along with the rest of your portfolio. Depending on how you want to diversify your portfolio, research all your options and invest in the assets you feel comfortable with and understand clearly. Once you make an investment, sit back and monitor your asset.
Helpful tips for first-time alternative investors
You can apply many of the same investor tips to alternative investments that you can to traditional ones. When you are ready to start investing in alternative assets, be sure to clearly understand your financial goals and have a detailed plan on how you will meet them.
Researching and understanding all the costs, fees and risks before investing any money is also very important. Don’t approach your alternative investments as a get-rich-quick scheme just because they can potentially produce high profits.
Important attributes of alternative investments
Although alternative investments vary widely, they tend to have some common attributes. Investments like hedge funds and private equity have high fees and minimum investments to get started, which makes some options less available to the average investor. Alternative assets like property, high-value artwork, lumber and basketball cards all tend to be illiquid as you don’t trade them on public exchanges. Plus, it may be difficult to find buyers. Receiving valid financial data on some alternative assets can also be challenging.
How much of an alternative investment should you make?
One of the most common investing mistakes you can make is allocating all of your funds into one asset. Portfolio diversification is essential when dealing with external factors like market volatility and inflation. Alternative investments allow for more chances to vary your investments. The overall amount you should invest depends on your budget, risk tolerance and financial goals.
What ratio of alternative and traditional investments is best?
There is no set ratio for investing in alternative versus traditional assets. Some financial advisors recommend allocating 10% to 20% of your investment portfolio to alternative assets to diversify your portfolio. At the same time, J.P. Morgan states that private bank clients are investing up to 30% of their portfolios into alternative assets. Ultimately, how much you invest in alternative investments depends entirely on your comfort level.
How are alternative investments regulated?
The Securities and Exchange Commission (SEC) regulates alternative investments. However, the regulations are somewhat ambiguous compared to traditional securities and other asset classes. Because there is a lack of regulation, alternative investments tend to invite a certain amount of scams and fraud that you must be careful of.
Deciding if alternative investments are right for you
Most alternative investments are high-risk, high-reward assets, but you can use them to diversify your portfolio and hedge against inflation. Because alternative investments can be complex, expensive and illiquid, they are not for everyone. That said, they can offer excellent opportunities. Be sure to research all aspects of a potential alternative asset before investing.