Alternative investments, also known as alternative asset classes, can be a great way to diversify your investment portfolios. Not only do alternative investments offer more significant potential for higher returns, but they also can reduce the overall risk associated with more traditional investments.
This guide will provide an overview of why alternative investments should be part of an investor’s portfolio and what to look for when considering these alternative options.
Definition of Alternative Investments
Alternative investments, also known as alternative assets, are defined by the U.S. Securities and Exchange Commission (SEC) as investments that do not fall into stocks, bonds, or cash. Alternative investments can provide a valuable way to diversify a portfolio since they usually don’t correlate with traditional markets and can be less volatile than other investments.
Examples of alternative investment assets range from collectibles like art or antiques to real estate, commodities, hedge funds, private equity, and venture capital funds.
Many alternative investments require high upfront costs, which could result in lower returns for individual investors than for institutions and wealthy individuals with complex investing needs. Therefore, before entering into an alternative investment arrangement, it is essential to:
- Understand the levels of risk involved and ensure that it is appropriate for your financial situation.
- Understand the terms of any alternatives they are considering.
- Seek independent advice if needed before committing any funds to an investment opportunity.
Types of Alternative Investments
Alternative investments, like real estate, commodities, hedge funds, and derivatives, are assets that typically have a lower correlation to stock and bonds and can provide diversification and potential for higher returns. There are a variety of alternative investments, each with risks and costs associated with them.
In this article, we’ll explore the different types of alternative investments available on the market today:
Real estate investments offer numerous benefits when compared to traditional stocks and bonds. These advantages include more control over the investment, greater potential for appreciation, and regular income from rental payments. However, seeking experienced and qualified advice before committing funds to real estate investments is essential, as risks can affect returns.
Real estate can be subdivided into two broad investment categories: residential and commercial. Residential real estate consists of residential units such as single-family homes, apartments, and condominiums. The investment opens up the opportunity to generate a steady income in rent, property appreciation, or both. On the other hand, commercial real estates, such as office buildings, retail centers, hotels, and malls, provide advantages between higher revenue potential through rent collection but require more research than residential properties when considering a purchase.
Other alternative real estate investments may include:
- Crowdfunding platforms allow investors to participate in larger properties or pools of capital with smaller contributions.
- REITS – Real Estate Investment Trusts which offer exposure thru public markets in an exchange-traded fund.
- Hard money lending involves providing secured loans for those with a lack of credit willing to cover loan costs for higher interest rates – all offering varying risk/reward profiles unique to each type of investment.
Commodities represent a broad asset class that can provide diversification benefits to an investor’s portfolio. These investments are usually considered relatively safe compared to stocks, bonds, and real estate. Commodity investments generally enhance a portfolio’s overall returns and minimize risk. They can be purchased as futures contracts, physical holdings, or exchange-traded funds (ETFs).
Investors may invest in commodities for many reasons, including hedging against inflation or currency risk and taking advantage of speculation opportunities related to economic events occurring around the world. Commodities may also offer attractive return potential compared to traditional stocks and bonds.
Common Examples of Commodity Investments:
- Natural Gas
- Livestock Futures
- Coffee Futures
- Cocoa Futures
- Grain Futures
- ETFs tracking a commodity index
Private equity is an increasingly popular alternative investment that focuses on value creation by taking ownership of companies rather than investing money in debt or stocks. Private equity investors look for long-term investments to increase the value of their portfolios over time. Private equity can take many forms, from venture capital funding start-ups with significant growth potential to buying entire companies to restructuring within the existing organization.
Let’s explore some of the different types of private equity investments:
- Venture Capital: Venture capital is the act of providing start-up funding to promising young companies. Investors expect high returns from rapidly growing a company and cashing out through public stock offerings or selling the company outright.
- Buyouts: A buyout occurs when a private equity investor purchases a controlling interest in a company by buying its stock or acquiring assets. Buyouts are often used when acquiring mature companies with significant cash flow and support, including divisions of larger corporations or entire corporations.
- Growth Investing: Growth investing focuses on business expansion and long-term growth potential through investments such as additional facilities, management personnel, marketing programs, and new product development. Investors provide capital for these short-term costs and hope for future gains through expanded markets, increased production levels, and higher operating profits.
- Mezzanine Financing: Mezzanine financing involves financing subordinated to any external debt financings senior lenders may have already provided (hence the term “mezzanine”). It carries higher interest rates than mortgage loans on fixed assets for inputs such as new equipment, generally ranging from 10% – 14%. The return prospects are worth considering as part of a diversified portfolio strategy.
Hedge funds are an alternative investment that takes much skill to manage. Hedge funds often use strategies like short-selling, leveraging, and concentration on a few specific markets to reduce risk. Financial institutions often establish hedge funds, or investors can create their own.
Hedge funds offer exposure to different parts of the global markets that traditional investments may not be able to access as easily. For example, some hedge funds specialize in currencies or commodities. In contrast, others trade options or buy areas of the market that may be more volatile than typical stock and bond investments. In addition, hedge fund managers typically use leverage and derivatives to increase their returns while minimizing the risk of loss.
The type of returns offered by hedge funds vary widely based on the specific strategies used in each fund management portfolio. However, certain hedge funds – such as managed futures– tend to produce higher returns than traditional investments like stocks and bonds when adequately managed. The downside is that these types of investments can also involve higher levels of risk, so it’s essential to evaluate a fund carefully before investing in it.
Art and Collectibles
Art and collectibles represent a sector of the alternative investment market that has grown in popularity. These investments can be physical or digital assets, such as artwork, photography, coin collections, antiques, and other memorabilia. While some paintings and collectibles appreciate over time due to their scarcity and demand, others are less likely to increase in value.
Art appeals to many investors for various reasons, such as an aesthetic appeal or emotional significance related to its history or previous owner. For those considering this type of investment, it’s essential to research and understands each asset class’s unique characteristics before investing large sums. It is also important for collectors to realize that art is often subject to varying market dynamics as tastes change over time; careful portfolio management is essential for success. Additionally, art funds offer an alternative way of gaining exposure to this asset class without having the exact commitment costs associated with purchasing individual pieces.
Although it can take time for an artwork or other collectible asset appreciation in value, there has been increasing demand among investors looking for more modest yet appealing returns compared with conventional higher-risk markets such as equities. Art investments also bring potential tax benefits; qualified works may be eligible for certain tax deductions depending on how they were bought or sold within certain countries’ regulations.
Advantages and Disadvantages of Alternative Investments
Alternative investments are not part of the traditional stock, bond, and cash portfolios. While these investments have the potential to provide higher returns than conventional investments, they also come with their own set of risks and rewards.
In this guide, we will look at the advantages and disadvantages of alternative investments and discuss whether they should be included in your portfolio.
Alternative investments can provide investors with a way to diversify their portfolios, potentially create additional income and provide the potential for higher returns when compared to conventional investment products. Additionally, many of these investments are relatively uncorrelated to traditional investments like stocks and bonds, which makes them an attractive addition to an otherwise standard portfolio.
Advantages of alternative investments include:
- Potential for higher returns compared to stocks and bonds. Alternative investment products often offer higher returns as they involve private placements, direct access to specific markets, or business ventures unavailable through conventional vehicles. Plus, many alternative investments do not react directly with the stock market, providing investors with a more diversified portfolio and less risk of capital losses from volatile markets.
- Diversification capability: Alternative investments can allow investors to diversify their portfolios into asset classes that are not accessible through traditional vehicles – such as real estate, hedge funds, or private equity funds. It can spread out risk more evenly and reduce overall portfolio volatility.
- Tax benefits: Many alternative investments, such as real estate investments, have tax advantages that traditional investment products do not offer. These benefits can help increase the overall return on investment over time by reducing taxes on built-up gains and interest-earned income.
- Accessibility: Many alternative investment vehicles require less capital than stocks or bonds, making them accessible even for smaller investors who are just starting in the world of investing or want to slowly add different investment options into their portfolio without breaking the bank each time they make a purchase.
Alternative investments come with certain risks, and it is essential to know them before deciding if they suit you. One disadvantage of this type of investment is that many alternative investments have high management fees, making them more expensive than typical stock or bond investments. Some alternatives can also have liquidity issues since not all can easily be sold or converted into cash quickly. Alternative investments often require a more extended holding period, meaning it can take years to realize a return on your initial investment.
Additionally, alternative investments may not always perform as expected due to unforeseen market changes, instability in global economies, or other outside factors. Because these investments involve higher costs and risks than traditional investments, investors should explore all available options and carefully consider the benefits before investing in any alternative investment.
How to Invest in Alternative Assets
Alternative investments encompass various asset classes, from real estate to private equity to venture capital. Investing in these alternative assets can offer a degree of diversification to your overall portfolio.
In this guide, we will discuss the different types of alternative investments and how they can fit into your overall investment strategy:
Research and Due Diligence
Research and due diligence are vital factors when investing in alternative assets. Such investments include hedge funds, venture capital, private equity, real estate, energy projects, and precious metals. Many of these investments are relatively illiquid and involve more risk than stocks or bonds. Consequently, it is important to research the asset and analyze its expected return before deciding whether or not to invest.
When researching alternative asset classes, investors should seek reliable sources that provide objective information about the type of asset they are considering—including information on past performance and risk/return characteristics. Additionally, investors should check reports or filings from government agencies such as the Securities and Exchange Commission (SEC) for additional insight into investment risks.
Another critical aspect of due diligence is analyzing the quality of management teams within an alternative asset class. Equally important is ensuring a financial institution’s practices balance performance expectations and risk management prerequisites so investors can make informed decisions about their investment strategies. Further steps in this process include:
- Inspecting fees associated with the different types of investments they may be pursuing.
- Confirming liquidity capabilities across different asset classes — including access to leverage where necessary.
Investors should also consider diversifying their portfolio when investing in alternative assets, given the increased risk exposure with these investments compared to traditional markets like stocks or bonds. It can be done by:
- Selecting several different types of alternatives that have low correlations amongst each other.
- Selecting multiple managers across a single strategy.
- Investing in international strategies.
- Including exposure to both passive and active funds.
- Approaching specific strategies with different approaches (e.g., through joint venture funds).
Finally, investors should regularly monitor their investments to ensure their portfolios stay well-diversified over time and comply with any relevant regulatory compliance requirements for the jurisdiction in which they are operating.
Finding the right balance between your risk tolerance and return goals is essential when investing in alternative assets. By understanding the potential risks and rewards of each asset class and researching the background of any companies or products you plan to invest in, you can make strategic decisions that align with your goals. Here are some strategies you can use when investing in alternative assets:
- Diversification: Alternative investments can help diversify a portfolio by adding exposure to unique sources of return. This strategy is especially beneficial for those who have exposure to stocks and bonds but want to limit their exposure to traditional markets. By diversifying into asset classes such as real estate, private equity, venture capital, futures, and derivatives, investors can potentially reduce their portfolio’s overall risk.
- Cost Control: Investing costs such as commissions and management fees can erode returns over time. When investing in alternative investments such as real estate or private equity, investors should closely monitor fees associated with those assets, so they don’t end up with unexpected costs that eat away at their returns.
- Risk Management: Alternative investments involve a high degree of risk due to their relatively illiquid nature and low levels of transparency or oversight compared to traditional investments like stocks or bonds. Investors must research before committing capital to understand the risks involved with each investment and make informed decisions on how much capital they are willing to allocate toward a particular asset class.
- Research & Due Diligence: Unlike standard publicly traded securities on exchanges worldwide that provide detailed financial reports and analytics on holdings, alternative investments lack data transparency due to various regulatory restrictions. To properly assess an alternative investment opportunity before allocating capital, investors must conduct ample research, including talking with current & prospective limited partners (investors) and obtaining independent legal & financial advice from qualified professionals who specialize in these investment vehicles.
When you consider investing in alternative assets, it’s essential to understand the different types of risk present – such as liquidity, market, and counterparty risks. However, their complexity makes it challenging to accurately gauge alternative investments’ potential return and associated risks.
- Liquidity Risk: This risk is associated with illiquid asset classes, such as real estate or private equity, with no public secondary market for investors. As a result, it’s often difficult and costly to liquidate positions quickly, meaning you may have to wait a while before receiving proceeds from the sale of your investment.
- Market Risk: This type of risk occurs when the current market value of a portfolio is less than what was invested initially – meaning that the investor has lost money on its investment. In many alternative investments, this could be a significant concern if there is not enough diversification across different securities or classes of assets.
- Counterparty Risk: This refers to the potential for loss caused by an inability by one party (the counterparty) to fulfill its contractual obligations – for example if one party fails to receive payment or goods as agreed upon in a contract or transaction document. As such, it’s essential to understand all aspects of any investment agreement before entering into it, specifically the potential risks and rewards associated with the deal structure.
Alternative investments are worth exploring as they can diversify the portfolio and offer potential returns in different market conditions. However, many alternative assets come with high entry and exit costs, and their performance may be much more volatile than traditional investments. Investors should also remember that this asset class may behave differently than others, which could impact their portfolio.
It is highly recommended that investors consult a qualified financial advisor when considering alternative investments to ensure that the risk profile is aligned with their investment goals. With the right advice, investors who understand the nature of these investments can enjoy potentially higher returns through additional avenues provided by the alternative market.
Frequently Asked Questions
Q: What are alternative investments?
A: Alternative investments are non-traditional assets not typically found in a standard portfolio, such as stocks, bonds, and cash. Examples of alternative investments can include real estate, private equity, hedge funds, commodities, and art.
Q: Why would someone invest in alternative assets?
A: Alternative investments can offer the diversification, which can help reduce risk in a portfolio. They also have the potential for higher returns than traditional investments and can provide a hedge against inflation.
Q: Are alternative investments only for high-net-worth individuals?
A: No, alternative investments are becoming more accessible to a broader range of investors. Many options are now available to invest in alternative assets through mutual funds, ETFs, and crowdfunding platforms.
Q: What are the risks associated with investing in alternative assets?
A: Alternative investments can be less liquid than traditional investments and may have higher fees. They can also be subject to market volatility and economic downturns. Therefore, it’s crucial to research potential investments and understand the risks involved thoroughly.
Q: How can I get started investing in alternative assets?
A: Consult with a financial advisor to determine if alternative investments suit your portfolio. Research different options and platforms for investing in alternative assets and understand the costs and risks involved.