Alternative investments frequently appear as options for investors looking for ways to diversify their volatility exposure and potentially generate additional returns beyond stocks and bonds. Alternative investments can be a compelling choice for a diverse portfolio for the right investor. Let’s see the different types and examples of alternative investments and fund.
What are Alternative Investments?
To understand how alternative assets, you must first understand two related concepts known as “asset classes” and “asset allocation.“
An asset class is a type of asset that has a specific set of characteristics. There are a few “core” asset classes that investors should consider adding to their portfolios. These are some examples of alternative investments:
- Cash and cash equivalents
- Stocks
- Bonds
In the broadest sense, an alternative investment, or alternative asset, is any type of asset that does not fall into one of these three categories. So, asset allocation refers to how you divide your investments among different types of assets.
Alternative Investments Real World Examples
Alternative investments examples that you might come across in the real world include:
- Real estate, including directly owned property, real estate limited partnerships, real estate development corporations, and real estate investment trusts (REITs)
- Master limited partnerships can own and operate everything from oil pipelines to theme parks.
- Tax lien certificates
- Stock or membership units in a privately held company
- Commodities include precious metals such as gold, silver, platinum, and palladium, as well as crude oil, natural gas, ethanol, corn, soybeans, wheat, cocoa, coffee, and sugar.
- Farmland
- Timberland
- Mineral rights
- Copyrights, patents, and trademarks are examples of intellectual property.
- Private Mortgages
- leasing of equipment
- Structured settlements
- Art and collectibles
- Private equity
- Wine
- Numismatic coins
- Venture capital
- Peer-to-peer lending
- Hedge funds
- Annuities
Types of Alternative Investments
Here are some examples of common alternative investments types:
- Private equity.
- Venture capital.
- Private debt.
- Hedge funds.
- Real estate.
- Commodities.
#1. Private Equity
Private equity invests in non-publicly traded companies. According to Black, investors’ money may be unavailable for up to ten years while they wait for the private equity fund to sell its holdings in an initial public offering, to a strategic buyer, or in a merger.
Transparency is an issue because buyers frequently commit to investing in a blind pool and won’t know what the company is until the manager finds the investment.
#2. Venture Capital
Venture capital is a subset of private equity. It invests in early-stage companies that have the potential for rapid growth or are looking to expand rapidly in a new or innovative space. Because many of these companies do not yet have revenues or profits, there is a high risk of failure, but there is also a high reward if a firm succeeds.
Private equity and venture capital may necessitate capital calls from investors.
An investor may contribute $200,000 to a fund, but the managers take money in $50,000 increments over a two-year period. If investors do not have the earmarked funds when the manager requires them, they may face severe penalties.
You have to be prepared to have that built into your financial plan as if you’ve already invested the entire amount.
#3. Private Debt
According to Michael Harris, director of a family office and partner with Verdence Capital Advisors, some companies look to private lenders for funding in the same way that some look to private equity. Private debt, also known as private credit, provides investors with the opportunity to earn higher yields than those available in public markets.
There are various types of private debt, including mezzanine and senior debt, which are higher on the payout structure in case of default and are less risky. Distressed credit is considered riskier because it invests in the debt of distressed companies.
#4. Hedge Funds
Many strategies based on hedge funds attempt to provide some sort of return while also acting as a buffer when traditional assets fall. According to Harris, there are 16 common types of hedge-fund strategies. Long-short equity is a common strategy. Managers will invest in a company that has the potential to grow in value, but they may also sell short or bet against the company and profit if its value falls. Absolute return strategies, also known as “all-weather strategies,” are used by hedge funds to generate returns regardless of what traditional markets are doing.
According to Harris, a third common strategy is to be market neutral. Market neutral funds attempt to reduce systematic risk created by factors such as exposures to sectors, market-cap ranges, investment styles, currencies, or countries, in addition to having a 50/50 long-short exposure in the portfolio.
#5. Real Estate
According to Sal Bruno, managing director and chief investment officer for IndexIQ, an exchange-traded fund provider that offers alternative asset ETFs, real estate are alternative investments when people purchase investment property such as office buildings or residential apartments. Investors who do not want to be landlords can use a broker to purchase private real estate investment trusts or REITs. REITs that are publicly traded are traded on stock exchanges.
Although public real estate investment trusts have some real estate characteristics, they are often considered to be very equity-oriented. This is because they are traded on exchanges.
Timberland and farmland are two other private real estate investments.
#6. Commodities
Commodities are mostly natural resource investments, such as crude oil, corn, and coffee. Because they are real assets, they are frequently thought of as an inflation hedge.
So, commodity trades in the futures market, and contracts mature at specific times throughout the year, according to Bruno.
To maintain the position, investors must sell the contract before it matures and purchases a new one. Sometimes the new contract is more expensive than the old contract, which can have an impact on performance.
Some commodity markets, such as gold or oil, are also available through ETFs.
Alternative Investments Regulations.
Everyone in the market follows the same rules: don’t lie, don’t cheat, and don’t steal, so they have complete regulations in that regard.
However, alternative investors differ significantly from traditional public markets such as stocks, bonds, and mutual funds. Publicly traded investments are governed by the 1940 Investment Act, which governs investment funds. Two sections of that act define accredited investors and qualified purchasers in the context of private-placement exemptions. According to Black, if a fund manager promises to only sell their fund to accredited and qualified purchasers, that is a private-placement exemption from the act, and the rules do not apply to that fund.
This exemption allows alternative investments fund managers to use a maximum level of leverage or be extremely illiquid, and they are not required to report a daily net asset value, regular holdings reports, or a prospectus, for example. There isn’t always full disclosure, but that’s part of the point of these investments. These managers are skilled at concealing their actions.
Instead of a prospectus, investors receive a private-placement memorandum of understanding, which specifies the fees, liquidity, and type of investment. “If you tell your investors you’re a commodity fund, the SEC wants you to be a commodity fund.” They don’t want it when it comes to real estate. They must abide by the terms of those agreements.
Investors may receive monthly or quarterly data, but it is frequently delayed. As of early January, hedge-fund returns were current as of November, and private-equity returns were current as of June.
Alternative Investments: Their Benefits and Drawbacks
Alternative investments, like other types of investment, have advantages and disadvantages:
Advantage:
#1. Diversification.
According to Harris, the two main reasons for including alternative investments, portfolio diversification and return enhancement, must be carefully considered. Alternative investments should have a low correlation to traditional markets, but this does not imply a negative correlation, which is a common misunderstanding, he says.
Lowly correlated means that on a scale of one to one, those funds are attempting to get as close to zero as possible. It means that they will occasionally use traditional assets. And every now and then, they will move in the opposite direction. It is not guaranteed that those alternative investments will always perform well when markets fall.
#2. Exposure to one-of-a-kind investments.
Alternative investments enable people to gain access to markets they would not otherwise be able to access, such as land or being an early investor in a startup fund, which can pay off handsomely for patient investors.
Disadvantages
#1. Long lock-up
While alternative investments such as private equity can boost returns, it can mean locking up your investment money for 10 years, which is why investors must carefully consider how much of a return premium they may receive over the liquid public markets, according to Harris.
#2. It is complicated.
These are extremely complex investments that necessitate meticulous research. Professional investors like Harris will spend a significant amount of time researching strategies and interviewing managers. “There is a huge difference between top-quartile managers… and bottom quartile managers.” “In some cases, it can be 15 to 20 percentage points in a given year,” he says.
Conclusion
Historically, most alternative investments have a 2% annual upfront fee, with managers taking 20% of the gains when the fund distributes the money.
According to McLean, most people gain access to alternative assets through a financial institution or a financial advisor, but emerging digital platforms are beginning to offer methods to acquire directly. He believes that for first-time purchasers, it is still better to work with a professional who understands the asset class, its rewards, and obstacles.
Liquid alts, such as mutual funds and ETFs that provide exposure to alternative assets, are gaining appeal. So, these regulated securities are open to the public and provide daily liquidity, a prospectus, and a list of ownership. Because of the constraints imposed on regulated securities, such as limits on leverage and diversification, it is not the same as direct alternative asset ownership. These can be a good way to get started in the space, but the expense ratios can be higher than in traditional market vehicles and not as diverse.
Alternative Investments FAQ’s
What are the 4 investment alternatives?
The 4 main types of investments alternative are Stocks, bonds, mutual funds, and real estate.
What are the safest investments?
Certificates of deposit (CDs), money market accounts, municipal bonds, and Treasury Inflation-Protected Securities (TIPS) are among the safest types of alternative investments.
