Alternative investments seem to be gaining popularity among investors in recent times. Stocks, bonds, and mutual funds are only some of the several asset classes available. And it’s not unusual for investment advisers to recommend an asset allocation between 5% to 15%. Of course, this depends on a client’s risk tolerance.
Alternative asset classes can behave very differently from stocks and bonds. And some exist in a far less transparent and unregulated environment that can introduce additional risk. In fact, many of these instruments require expert knowledge, making them unsuitable for a large majority of the investing public who don’t have access to expertise from an adviser.
So why even consider this space at all? It’s simple. Where there is a risk, there is also a reward. And since many alternative investments are uncorrelated with stocks and bonds, they can provide plenty of diversification benefits.
What are alternative investments?
An alternative investment refers to any financial instrument that doesn’t fall into traditional asset classes of stocks, bonds, funds, or cash.
In many cases, they are not publically traded on a centralised market. This makes them illiquid, increasing the difficulty of turning these assets back into cash at the current market value. Furthermore, depending on the asset, they may exist in an unregulated space. This increases the chance of fraud with limited recourse available to recover funds.
However, exposure to alternative assets can provide potentially explosive returns if investors know what they’re doing. And they can help investors build a more diversified portfolio to hedge against stock market volatility, rising interest rates, and inflation.
8 types of alternative investments
While these types of assets often require expertise to understand and evaluate, alternative investing offers some noteworthy advantages.
1. Real Estate
Real estate is arguably one of the most accessible forms of alternative investment. And anyone with a mortgage already has exposure to this asset class. The goal is to invest in a property that will appreciate or generate rental income over the long term.
Instead of purchasing a property with a mortgage, other methods are available to invest indirectly in this space. For example, investors can buy shares in a real estate investment trust (REIT). This investment vehicle takes shareholder capital to purchase rental properties, returning any income generated via a dividend.
Other real estate investing methods include:
- Real estate mutual funds.
- Buy to let.
- House flipping.
- Real estate crowdfunding.
Real estate valuation can be challenging without the proper knowledge. Various approaches, such as discounted cash flow models, income capitalisation, and relative sales comparables, are used depending on the situation. Each valuation method has its advantages and disadvantages.
Commodities refer to natural resources, farmland, and timberland. These physical products don’t produce any cash flow. But their market prices change depending on global supply and demand. Prices are also highly correlated with inflation. Therefore, if a currency’s value drops, a commodity’s price will increase to offset this monetary devaluation.
Some examples of commodities include:
- Industrial Metals – Copper, Lead, Zinc, Aluminium, Cobalt
- Precious Metals – Gold, Silver, Platinum, Palladium
- Grands, Food & Fibre – Corn, Oats, Rice, Soybean, Rapeseed, Wheat, Milk, Sugar, Coffee
- Livestock & Meat – Cows, Pigs, Sheep, Beef, Pork, Chicken, Lamb
- Energy – Crude Oil, Heating Oil, Natural Gas, Propane
- Forest – Lumber, Pulp
- Other – Wool, Water, Rubber, Palm Oil, Amber
After acquiring this alternative investment, an investor can wait for the commodity price to increase before selling it at a profit. However, directly purchasing physical materials can incur additional storage and security costs. Therefore, it’s far more common for commodities to be traded using financial derivatives such as options, futures contracts, and swap agreements.
3. Private Equity
The vast majority of businesses are not publically traded. There are enormous investment opportunities within the private sector. But this can be a difficult region to access unless an investor has considerable capital.
There are generally three types of private equity:
- Venture Capital – Focuses on funding startup and early-stage companies.
- Growth Capital – Helps provide vital funding to mature enterprises seeking to expand or restructure.
- Buyout – Focuses on acquiring part or all of a private business. This could either be to take it public or as an attempt to turn a struggling company around.
Investing in a private equity firm is usually not an option for many investors. That’s because the minimum investment requirements can range between $250,000 to $25m. However, there are publically traded mutual funds that invest in the private sector on behalf of shareholders. These funds are an indirect method for private investors to invest in this alternative investment space.
4. Private Credit/Debt
Private credit or debt refers to any non-bank loan issued to a business not traded on an open market. Both public and private companies can take on private debt to fund operations or fuel growth.
Generally speaking, companies use private debt when they don’t qualify for a bank loan. This can make this alternative investment highly risky. But to compensate investors, these loans typically carry much higher interest rates. As such, providing that the borrower does not default on their loans, a lucrative stream of passive income can be established.
There are various ways to invest in the private debt market.
- Peer-to-peer loan marketplace.
- Private debt mutual funds.
5. Hedge Funds
A hedge fund is a more exclusive type of alternative investment. These businesses are usually established as limited partnerships. And exist to invest money on behalf of wealthy individuals as well as financial institutions such as pension funds and sovereign wealth funds. Hedge fund managers are paid an annual fee that’s linked to performance.
Hedge funds dabble in almost every type of asset class. They are generally less restricted in their investing activities than a mutual fund and often deploy multiple investing strategies simultaneously. The list of methods includes:
- Long/Short Equity.
- Short Only.
- Market Neutral.
- Arbitrage (Volatility, Merger, Convertible, Capital Structure, Fixed-Income).
- Global Macroeconomic.
Another common type of alternative investment is collectables. These are physical and digital products that have the potential to increase in value over time.
Some common examples include:
- Rare wines.
- Fine art.
- Vintage cars.
- Coins & Bank notes.
- Postal Stamps.
- Mint-condition toys.
- Baseball cards.
The price of a collectable is often determined by its scarcity and level of interest from other individuals. In most cases, these can be highly illiquid assets due to the difficulty of finding an interested buyer. However, over the long term, certain collectables can fetch a staggering return on investment.
For example, The Amazing Spider-Man Issue #1 comic, released in 1962 for $0.12, now fetches a price tag of $336,000!
Cryptocurrencies are a class of alternative investments that’s still relatively new. In recent years, interest in digital currencies has skyrocketed primarily due to the rise of Bitcoin and Ethereum. Today there are thousands of cryptocurrencies available, each working in slightly different ways.
However, with no cash flows being generated, the price of these assets moves likewise to that of a collectable. A key difference is that cryptocurrencies can be easily bought and sold through various exchanges, making them liquid. But as a consequence, these digital currencies are notorious for being highly volatile, behaving very similarly to penny stocks.
Traders seek to capitalise on this volatility to generate a return on investment. But due to the unregulated nature of this market, it’s prone to high levels of fraud, scams, and pump & dumb schemes that can leave unsuspecting investors with nothing.
8. Structured Products
The final type of alternative investment is structured products. These are highly specialised investment vehicles designed for sophisticated and institutional investors. Used incorrectly, these products can decimate a portfolio. However, this high level of risk also comes with a greater potential return. That’s why they’re popular with investment banks and hedge funds.
Some common examples of structured products include:
- Asset-Backed Security (ABS)
- Mortgage-Backed Security (MBS)
- Credit Default Swap (CDS)
- Collateralised Debt Obligation (CDO)
- Collateralised Mortgage Obligation (CMO)
- Collateralised Bond Obligation (CBO)
- Collateralised Loan Obligation (CLO)
- Collateralised Fund Obligation (CFO)
- Senior Stretch Loan (SSL)
Advantages of alternative investments
While these types of assets often require expertise to understand and evaluate, alternative investments offer some noteworthy advantages.
- Diversification – An investor can use alternative assets to diversify their investment portfolio. This can bring balance and reduce the overall level of risk exposure.
- Superior Returns – Investors are compensated with potentially superior returns as a reward for the high risk of investing in alternative assets. While there is never a guarantee, a successful alternative investment can reap enormous rewards compared to a conventional asset class.
- Inflation Hedge – Some alternative investments, such as commodities and real estate, can be immune to the adverse effects of inflation. This grants investors protection against the devaluation of money over time.
- Low Volatility – Excluding hedge funds and cryptocurrencies, alternative investments are less exposed to the broader public-traded market. As such, asset prices aren’t as heavily impacted by market forces resulting in increased portfolio stability.
- Low Correlation – Excluding crypto, an alternative asset class is typically uncorrelated with a traditional investment. As such, even risky alternative investments can still reduce the overall level of risk in a portfolio.
Disadvantages of alternative investments
As with every investment strategy, alternative investing has some significant disadvantages.
- Low Liquidity – Unlike equities, due to the nature of alternative assets, they cannot be easily converted to cash. The sale of these assets takes time, as it may be challenging to find buyers. This also increases the spread between the market and selling prices, harming an investor’s return.
- Lack of Regulation – Not all alternative asset classes are registered with market regulators. This makes scams, fraud, and misinformation more prevalent, potentially leading investors astray.
- Lack of Transparency – The lack of regulation also means there is no requirement for regulatory filing or standardised reporting structures. As such, comparing and analysing an alternative asset can be very challenging.
- Difficult to Value – The value of alternative investments can be highly subjective, making it difficult to pinpoint an exact market price.
- Higher Fees – Due to the extra work matching buyers and sellers, the fees for buying and selling alternative assets can be substantial.
- High Minimum Investments – Some alternative assets require investors to invest large initial capital. This raises the barrier to entry for individuals with a lower net worth.
How are alternative investments regulated?
Due to the diversity of the different types of alternative investments, there is no single regulatory authority. And in many cases, there is no regulation at all.
The Commodity Futures Trading Commission (CFTC) regulates investing in commodities using financial derivatives in the United States. Meanwhile, the Securities and Exchange Commission (SEC) oversee federal securities laws. In the United Kingdom, the Financial Conduct Authority has this responsibility.
In the case of hedge funds and private equity firms, a lot of regulations can be avoided by accepting capital exclusively from accredited investors. These are wealthy or knowledgable individuals considered skilled enough to make informed investment decisions even in asset classes that lack transparency.
As for crypto and collectables, no regulation exists. As such, investors must be wary of illegal activity, scams, and fraud.
What to consider before investing in alternative assets?
The potentially higher returns offered by alternative investments can make them attractive. However, there are several factors investors need to consider before jumping into this space.
- Does the asset match the risk tolerance of the investor?
- Will the asset help in achieving specified investment goals?
- Can the asset be verified by independent third parties to ensure it’s legitimate?
- Can the seller be trusted?
- Does the potential return merit the added risk?
The bottom line
Investors need good knowledge of alternative investments before adding them to their portfolios. In many cases, it may be inappropriate to invest in these assets despite the potential rewards. But for those with the confidence and skill to make an informed decision, alternative investments can provide valuable diversification and protection against general market volatility.
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This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial advisor if necessary.