Building a diversified portfolio is crucial for long-term wealth creation. In the medium to long term, diversification increases returns by lowering overall portfolio volatility, and minimizing losses brought on by market shocks, such as the volatility this year associated with COVID-19.
By purchasing a variety of stocks, bonds, and/or other products linked to public markets, one can diversify their portfolio.
However, investors ought to think about alternative investments for even greater diversification. There are several advantages to diversifying your investments beyond classic stocks and bonds.
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The information in this article is for general guidance only. It does not constitute financial, legal, or tax advice, and is not a recommendation or solicitation to invest. Some facts may have changed since the time of writing.
What Is an Alternative Investment?
A financial asset classified as an alternative investment is one that does not fit into the traditional investment categories.
Stocks, bonds, and cash are examples of traditional categories. Alternative investments may include hedge funds, managed futures, art and antiquities, commodities, derivatives contracts, and private equity or venture capital. Another common category for real estate is alternative investment.
Due to their complexity, lack of regulation, and level of risk, the majority of alternative investment assets are held by accredited, high-net-worth individuals or institutional investors.
Particularly when compared to mutual funds and exchange-traded funds (ETFs), most alternative investments require high minimum investments and have high fee structures.
Additionally, there are fewer opportunities for these investments to advertise to prospective investors and publish verifiable performance data.
Although initial minimum investment and upfront investment costs for alternative assets may be high, transaction expenses are usually lower than those for conventional assets because of lower levels of turnover.
In comparison to their traditional counterparts, the majority of alternative assets are relatively illiquid.
Since there are likely far fewer buyers for an 80-year-old bottle of wine than there are for 1,000 shares of Apple Inc., for instance, investors will probably have a lot more trouble selling the latter than the former.
Since the assets and the transactions involving them are frequently uncommon, investors may even struggle to value alternative investments.
For instance, a seller of a 1933 Saint-Gaudens Double Eagle $20 gold coin might find it challenging to estimate its worth because only 13 of these coins are known to exist, and only one of them is permitted to be legally owned.
What Distinguish Alternative Investments from Others?
The following characteristics almost universally distinguish alternative investments from conventional forms of investment:
1. Minimal Correlation With Traditional Investments
Since there are opportunities for portfolio diversification due to the low correlation, this may be extremely advantageous for prospective investors.
2. Finding The Underlying Value Is Difficult
When it comes to valuation, alternative investments are frequently inherently complicated. Alternative investment valuation might call for specialized knowledge, and some exotic investments, like fine art, might exhibit erratic demand trends. The valuation may also be complicated by the fact that they may be special in some other way.
3. Very Little Liquidity
In general, and especially when compared to traditional investments, alternative investments have a low level of liquidity.
Because there are no centralized markets and some assets are in lower demand than traditional investments, this low liquidity can be explained. Additionally, some investments have limitations on when you can withdraw your money.
4. Expensive Purchasing Cost
Alternative investments frequently have high acquisition costs. Some alternative investments, like hedge funds, have minimum investment requirements and fees.
Types Of Alternative Investments
1. Private Equity
The broad term “private equity” refers to financial investments made in privately held businesses or those that are not publicly traded on a stock exchange like the New York Stock Exchange. Private equity is divided into a number of categories, including:
- Venture Capital: focuses on early-stage business ventures and startup businesses
- Growth Capital: aids established businesses in growing or restructuring
- Buyouts: when a business or a portion of it is bought outright
The partnership between the company receiving capital and the the investing firm is a key component of private equity.
Private equity firms frequently offer their investee companies benefits beyond just capital, such as industry knowledge, help finding talent, and mentorship for startup founders.
2. Real Estate
Real property comes in a variety of forms. Land, farmland, and timberland are all examples of real assets, as is creative works of art. But the most prevalent and largest asset class globally is real estate.
In addition to its size, real estate is an intriguing asset class because it resembles bonds and equity in that property owners receive current cash flow from renters and aim to increase the asset’s long-term value, or capital appreciation, respectively.
Valuation presents a challenge in real estate investing, as it does with other real assets. There are a variety of techniques for valuing real estate, each with advantages and disadvantages, such as discounted cash flow, income capitalization,and sales comparable.
Strong skills in valuation and knowledge of when and how to apply different techniques are essential if one is to succeed as a real estate investor.
3. Private Debt
Investments that lack bank financing (i.e., a bank loan) or open market trading are referred to as private debt. The word “private” is crucial because it refers to the investment instrument rather than the debt borrower since both public and private companies can obtain debt using private debt.
Leveraged private debt is used by businesses when they require additional funding to expand. Private debt funds are the businesses that issue the capital, and they typically generate revenue through interest payments and loan repayment.
4. Commodities
The majority of commodities are natural resources like agricultural goods, natural gas, oil, and precious and industrial metals. Commodities are also real assets.
Due to their immunity to fluctuations in the public equity markets, commodities are regarded as a hedge against inflation. Supply and demand also affect the value of commodities; higher demand for a given commodity drives up its price, which benefits investors.
Trading in commodities dates back thousands of years, making them hardly new to the world of investing. The first formal commodity exchange may have taken place in the 16th or 17th centuries in either Amsterdam, Netherlands, or Osaka, Japan.
Trading in commodity futures was initiated by the Chicago Board of Trade in the middle of the 19th century.
5. Hedge Funds
Hedge funds are investment companies that trade in relatively liquid assets and use a variety of investing techniques in an effort to maximize returns on their investments.
Long-short equity, volatility arbitrage, market neutral, and quantitative strategies are just a few of the specialties that hedge fund managers can use to carry out their strategies.
Hedge funds are restricted to high-net-worth individuals and institutional investors such as pension funds, endowments, and mutual funds.
6. Structured Products
Fixed income markets—those that offer dividend payments to investors, such as corporate or government bonds—and derivatives, or securities whose value is derived from an underlying asset or group of assets, such as stocks, bonds, or market indices, are typically involved in structured products.
Credit default swaps (CDS) and secured debt obligations are a couple of examples of structured products (CDO).
Structured products, which can be complicated and occasionally risky investment products, give investors a mix of products that is specifically designed to meet their needs.
They are typically produced by investment banks and made available to hedge funds, businesses, or individual investors.
Structured products are a relatively new addition to the investing world, but the financial crisis of 2007–2008 probably made you aware of them.
The rise of the housing market prior to the crisis led to the popularity of structured products like CDOs and mortgage-backed securities (MBS). People who had invested in these products experienced significant losses when housing prices fell.
7. Collectibles
Collectibles come in a variety of forms, including:
- Fine art
- Mint-condition toys
- Rare wines
- Vintage cars
- Stamps
- Baseball cards
- Coins
Purchasing and maintaining tangible assets in the hopes that their value will increase over time is the definition of investing in collectibles.
These investments might sound more exciting and fun than other kinds, but they can be risky because of the high costs of purchase, the lack of dividends or other income until they are sold, and the possibility of asset destruction if not stored or cared for properly.
Experience is the most important qualification needed for investing in collectibles; to see any return on your investment, you must be a true expert.
Why Invest In Alternative Investments
1. Alternative Investments Are Generally Uncorrelated With Stock Market
Why invest in alternative investments? Because they are uncorrelated witht the stock market. Everyone who has invested in the stock market for any length of time has probably had some significant wins and significant losses.
Everyone who has retired or is about to retire has felt the heartburn of seeing their portfolio fall, sometimes in a dramatic way.
One of the primary motives behind investors looking for alternative investments is diversification. Two of the top reasons to invest in alternatives are diversification and competitive returns, according to a recent iCapital Network survey of top U.S. investment advisors.
When an investment is uncorrelated from the stock market, it does not fluctuate in response to market ups and downs.
Many investors mistakenly believe that holding REITS or other publicly traded alternatives will diversify their portfolios, only to discover that they are just as volatile and add little to the value of an investment portfolio.
And for this reason, we draw a crucial distinction between public and private options.
Private alternatives have become popular among investors as a way to diversify their portfolios and hedge against volatility.
They will have a hedge of protection in place and not have their entire investment portfolio negatively impacted if the stock market declines significantly as a result.
Even in a stable economy, the stock market is notoriously unpredictable, and alternatives are largely insulated from the erratic swings in the public markets.
Real estate is a prime example. Say you own a rental property or have investments in mortgage notes. Your borrower or tenant will continue making mortgage or rent payments despite the recent significant swings in the stock market.
2. Alternative Investments Are Passive Investments
Why invest in alternative investments? Because they are good passive investments.
The majority of time-constrained investors place a high value on their time, and actively managing a portfolio or asset requires a lot of effort. As most investors consider real estate to be where they should begin actively investing, let’s use that as an example.
They initially become enthusiastic about the idea of renting out a single-family home or, perhaps, a small multifamily apartment, but quickly learn how much work is required and how steep the learning curve is.
There are countless educators offering their “5 Step Plan to Success,” but in the end, finding co-investors, securing financing, structuring the deal, locating and assessing properties, etc., are all laborious tasks. Many investors give up at this point and simply assume that there are no other options.
But once more, as a result of the regulatory changes, a whole new world has emerged, many of which are entirely passive.
Aspen’s Funds, as an illustration, are entirely passive and don’t require ongoing management from investors. You can take advantage of the knowledge, group, and connections of seasoned operators when using truly passive funds or syndications.
3. Alternative Investments Have Low Volatility
The share price fluctuates in a traditional public investment based on a number of variables, many of which are not directly related to a company’s performance, but which are typically unrelated to an actual asset.
You avoid the volatility of publicly traded investments since shares of private investment are not publicly traded. And typically, a real asset is used to support your investment.
Even though the stock market experiences ups and downs, some claim that volatility is not a problem for long-term investors because it still averages between 6 and 8% over that time period (depending who you ask).
They fail to realize, though, that volatility makes compounding impossible. This situation may persuade you to think differently.
4. Alternative Investments Offer Strong Income
Why invest in alternative investments? Because they offer good returns. Many private alternative investments are cash-flowing, or paying you back in cash on a monthly or quarterly basis, though not all of them are.
These investments typically involve a cash-flowing real estate strategy. In the 8–10% range annually, some can generate significant income. Many funds are set up with preferred returns, where the investors receive their money first and in cash.
Anyone who has attempted to make money from public investments like CDs, bonds, or dividend-paying stocks is aware of the challenges involved.
The risk is increased just to produce a small yield due to the public markets’ potential for extreme volatility, as was already mentioned.
5. Alternative Investments Offer Direct Ownership
In the majority of public investments, what you are actually purchasing is a paper asset, the discounted value of anticipated future earnings. It’s not really something you own.
You are still a long way from having your name on the title to the real estate property, even if you invest in a REIT.
Fine art or wine that you purchase become your physical possession once you have paid for them. A rental property that you have purchased is yours solely. A lien is placed on a property if you purchase a mortgage note.
Or, you typically have direct ownership of any asset that a private fund buys if you invest in one of them. All investors in Aspen’s Income Fund become co-owners of a fund whose name is on the title deed of every mortgage it owns.
Investors would still own the mortgage and have the same rights as a lender to the property even if Aspen were to cease to exist.
6. Alternative Investments Offer Direct Tax Benefits
Why invest in alternative investments? Because they offer direct tax benefits.
Investing in alternatives may offer enticing tax advantages as well. You can keep a larger portion of your profit with many alternative investments thanks to their structure.
You become a co-owner of the fund or syndication in a lot of private alternative investments, and as a result, you directly receive tax advantages.
Pass-through depreciation and treatment of long-term capital gains are the two most significant tax advantages. Depreciation costs, a non-cash expense, are frequently subtracted from net income by real estate funds or syndications, lowering taxable income. Depreciation/depletion tax treatment for oil and gas investments is very favourable.
Investors become partial owners of the pass-through LLCs used by Aspen Funds. Our funds treat a portion of their income as long-term capital gains, which offers very advantageous tax treatment.
A common misunderstanding among investors is that qualified retirement accounts like 401(k)s and IRAs can be used to invest in private alternatives. You can grow your investment tax-deferred or even tax-free, depending on how you structure the investment.
What Is Alternative Investments Strategy?
Typically, there is little correlation between alternative investments and those in traditional asset classes. Due to their low correlation, they frequently move at odds with the stock and bond markets.
They are an effective tool for portfolio diversification due to this characteristic. A strong defense against inflation, which reduces the purchasing power of paper money, is provided by investments in hard assets like gold, oil, and real estate.
As a result, many large institutional funds, including pension funds and private endowments, frequently allocate a small percentage of their portfolios—typically less than 10%—to alternative investments, such as hedge funds.
There are alternative investments available to non-accredited retail investors as well. Exchange-traded funds (ETFs) and alternative mutual funds, also referred to as liquid alts or alt funds, are now offered.
The opportunity to invest in alternative asset classes, which were previously prohibitively expensive and difficult for the average person to access, is abundant thanks to these alternative funds.
Alt funds are governed by the Investment Company Act of 1940 because they are publicly traded, and they are registered with the SEC.
Who Should Use Alternative Investments?
Any person who wants to further diversify their portfolio should consider alternative investments.
Different alternative investing strategies will appeal to you more depending on your stage of life and interest in actively managing your investments.
Active Investors
Many well-liked alternatives in real estate and other industries open up for the active investor willing to put in the work.
Ownership of rental properties, home renovation, or private equity with a more active management style are excellent alternatives for active investors.
Passive Investors
Alternatives can offer the passive investor substantial returns without adding to management time.
Private equity, mortgage note funds, collectibles, and precious metals are suitable alternatives for this kind of investor.
Retired or Income-oriented Investors
Alternatives offer a low-volatility source of income, comparable to dividend investing, for people who are retired or on the verge of retirement or who are looking for income.
This allows investors to replace or supplement their retirement income and earned income. Alternative investments that are most suitable for this kind of investor will typically fall under funds, such as private equity funds, private real estate funds, private REITs, etc.
What Make Up The Main Features Of Alternative Investments?
In comparison to mutual funds and ETFs targeted at retail investors, alternative investments typically have higher fees and lower minimum investment requirements.
It can be more difficult to obtain verifiable financial data for these assets, and they frequently have lower transaction costs.
Alternative investments also tend to be less liquid than traditional securities, which makes it potentially challenging to even value some of the more unusual vehicles because of how little they are traded.
What Benefits Do Alternative Investments Offer To Investors?
Due to their low correlation with the bond market and stock market and their ability to hold their value during a downturn in the market, alternative investments are preferred by some investors.
Hard assets like gold, oil, and real estate are also good hedges against inflation. In order to diversify their holdings, many large institutions, including pension funds and family offices, look to alternative investment vehicles.
What Regulatory Requirements Apply To Alternative Investments?
Compared to more conventional securities, alternative investments are subject to less clear regulations.
The SEC regulates alternative investment vehicles, but their securities do not need to be registered. Because of this, the majority of these investment vehicles are only accessible to accredited institutions or wealthy investors.
Final Thoughts
In contrast to mutual funds, stocks, and bonds, non-traditional investments offer diversification and potentially higher returns, according to proponents of these types of investments.
The average investor now has access to these types of assets, they just don’t have a correlation to the stock market.
In addition, they have higher volatility than conventional investments like stocks, bonds, and mutual funds. Most are comparatively illiquid, making it challenging to sell them quickly.
These alternatives tend to be more complicated and frequently involve greater risks than conventional investments.
Instead of serving as the primary strategy of a long-term plan, an astute investor might view alternative investors as a tool for diversification.
Pained by financial indecision?
Adam is an internationally recognised author on financial matters with over 830million answer views on Quora, a widely sold book on Amazon, and a contributor on Forbes.
