What exactly are alternative investments?

Alternative investments can act as a buffer when stocks or bonds underperform

What exactly are alternative investments?

Alternative investments are assets that do not belong to conventional investment types, such as stocks, bonds and cash. Most alternative investment assets are held by institutional investors or accredited, high-net-worth individuals due to their complex nature and limited regulations.

What are the types of alternative investments?

The following are the main types of alternative investments:

Hedge funds
A hedge fund is a pooled investment structure operated by a professional manager with specific goals in mind – mainly to maximize returns and minimize risk. It got its name from hedging, a strategy wherein investors hold both long and short stocks to make sure they make money despite market fluctuations. For more information on hedge funds, read this article.

Private equity
Unlike other equities, private equity is not listed on stock exchanges. It refers to funds that institutional investors or high-net-worth investors place directly in private companies or in the buyout process of public companies. These companies usually then use the capital for their growth – be it for expanding their footprint, increasing their marketing operations, driving technological advancements or making strategic acquisitions.

Venture capital
Venture capital is an alternative asset class that invests equity capital in private start-ups and shows exceptional growth potential. The investment horizon is typically between three and seven years, and venture capitalists expect returns that are eight to ten times bigger than the invested capital.

Real assets
Not all investments are toward pools of funds or businesses; some are toward real assets such as precious metals and natural resources. Investing money in precious metals like gold and silver has been a practice since time immemorial. These assets have always been known to be the best hedge against market movements and currency fluctuations. Investors can invest in gold through gold coins, bullions or indirectly through sector-traded funds or exchange-traded funds (ETFs).

Other types of alternative investments include (but are not limited to) the following:

  • Annuities
  • Collectibles, such as artwork, coins with numismatic value, stamps, vintage cars and wine
  • Commodities, including crude oil, natural gas, ethanol, etc
  • Equipment leasing
  • Intellectual properties, such as copyrights, song rights, patents and trademarks
  • Master limited partnerships, which can own and operate everything from oil pipelines to capital-intensive theme parks
  • Peer-to-peer lending
  • Privately-underwritten mortgages
  • Real estate and all its many derivations, including directly-owned property, limited partnerships, real estate development corporations and real estate investment trusts (REITs)
  • Stock or membership units in a privately-held business
  • Structured settlements
  • Tax credits
  • Tax lien certificates

What are the benefits of alternative investments?

Alternative investments typically have a low correlation to traditional markets such as equity and fixed-income markets, which make them suitable for portfolio diversification. They perfectly complement the traditional investments. For instance, when a stock or bond underperforms, a hedge fund or private equity firm can mitigate the extent of losses over the long term. Alternative assets can be added or replaced based on individual investment goals and risk tolerance.

Many large institutional funds like pensions and private endowments have started allocating a small portion of their portfolios, usually less than 10%, to alternative investments. Investments in hard assets like gold and oil also serve as an effective hedge against rising inflation, as they are negatively correlated with stock and bond performance.

Compared to passive indexed investment, alternative investments call for active fund management. The complex nature of the assets, volatility and risk level of these investments require constant monitoring and revision of investment strategies as needed. Furthermore, wealthy investors who do not mind high management fees would definitely want to reap the benefits of high-end expertise.

And although alternative investments may have high initial upfront fees, transaction costs are typically lower than conventional investment types due to lower levels of turnover. Alternative investments held for a long period may result in tax benefits, as investments held for more than 12 months are subject to a lower capital gains tax than short-term investments.

What are the drawbacks of alternative investments?

Many alternative investments have high minimum investments and fee structures compared to mutual funds and ETFs. Most alternative assets also have lower liquidity than conventional assets. Due to the low trading volume and public market absence, these assets cannot be sold off quickly. Also, the data, facts and figures pertaining to alternative investments are difficult to obtain.

Alternative investments are also mainly close-ended funds, which mean that funds are not automatically reinvested but returned back to investors after a timeframe of 10 – 15 years. Alternative investments may also be prone to investment scams and fraud due to their unregulated nature. Thus, it is essential for investors to conduct due diligence.

When used correctly, alternative investments can be useful in minimizing risk and maximizing return at the same time. However, they are more complex than traditional investments and require careful attention on your part. If you want to benefit from alternative investments, you should commit to understanding them comprehensively so that you can find the best fit for your portfolio.