Alternative Investments

Alternative Investing

Alternative investments are financial assets that fall outside of the traditional categories like stocks, bonds, mutual funds, and Exchange-Traded Funds (ETFs). They can be an interesting part of a larger investment strategy because they can provide uncorrelated or higher returns, which can help a portfolio stay stable or add return during market changes.

Many of the most complex types, such as hedge funds and private equity, are traditionally offered only to institutional or high net worth, accredited investors due to their complex nature and high minimum investment requirements.

Types of Alternative Investments

Alternative investments can include a wide range of assets, some of which you might not typically think of as investments:

• Real Estate

  • This is often classified as an alternative investment and involves buying physical property to earn rental income or to sell for a profit later.

• Commodities

  • These are raw materials that are bought and sold, such as gold, silver, oil, natural gas, or agricultural products like corn and wheat.

• Collectibles

  • Items like fine art, rare coins, classic cars, high-end watches, or sports memorabilia can be considered alternative investments if they are bought with the expectation that their value will increase over time.

• Private Equity and Venture Capital

  • Private Equity involves directly investing in private companies that are not traded on a public stock exchange.

  • Venture Capital is a form of private equity that focuses on providing funding to start-up companies that have high growth potential.

• Hedge Funds

  • These are investment funds that use complex trading strategies, often employing derivatives and leverage, to try and generate higher returns than the general market.

• Derivatives

  • These are contracts (like futures and options) whose value is "derived" from an underlying asset, commodity, or index, such as the S&P 500.

• Cryptocurrency

  • Digital or virtual currencies like Bitcoin and Ethereum are considered alternative investments.

Upside and Downside of Alternative Investments, Particularly Hedge Funds & Private Equity

The Upside

• Diversification: The main goal is that their value often moves differently than the retail markets. Therefore, it helps balance out your total portfolio.

• Potential for Higher Returns: Some alternative investments have the potential to grow faster or offer higher returns than traditional stocks and bonds.

• Access to Unique or Data-Driven Ideas: Hedge fund portfolio managers typically apply unique or data-driven ideas to the markets that can present opportunities not found in typical investing.

The Downside

• Higher Risk: Sometimes, they are considered higher risk than traditional investments, which means there's a greater chance you could lose some, or even all, of the money you put in.

• Illiquidity: Unlike a stock you can sell in seconds, many alternatives can be illiquid. It can take a long time to sell a piece of real estate or an investment in a private company if you suddenly need the cash.

• Understanding Fees: The fees of alternative investments can be more or less complicated than ETFs or mutual funds. It is important to review the fee structure to understand when fees are collected and how they apply. To be clear, many alternative investment fee structures can actually be more favorable to the investor than a mutual fund or ETF.

Alternative Investment Allocation Decisions

The decision on your allocation level should be based on several factors, including:

• Spending Needs and Liquidity

  • Since alternative assets are often illiquid, your need for readily available cash is a primary consideration.

  • The more cash you need to spend from your portfolio annually, the less capacity you have to hold illiquid assets without risking a shortfall.

• Risk Tolerance and Investment Horizon

  • Investors with a long-term outlook, such as those planning for multiple generations or managing an endowment, may allocate more to alternatives for higher potential returns.

  • Investors with shorter time horizons, typically less than 15 years, are generally advised to avoid illiquid options like private real estate or private equity funds.

• Diversification Goal

  • Alternative assets can help diversify a portfolio, as they often have a low correlation with traditional assets like stocks and bonds. Strategies can be designed to optimize for yield generation or capital appreciation, depending on your goal.

Conclusion

Alternative investments are financial assets, such as real estate, commodities, private equity, hedge funds, and cryptocurrency, that exist outside of traditional categories like stocks and bonds. They are a valuable component of a broader investment strategy primarily because their value often moves independently of the stock market, which can offer diversification, potential for higher returns, and access to unique approaches to investing. It is important to understand the liquidity of the investment as well as its fee structure which are both typically presented along with the investment strategy. Finally, the decision to allocate to alternatives should be guided by a person's need for liquidity, their risk tolerance, and their investment time horizon.