Alternative investments can provide an interesting opportunity for investors to diversify their portfolios, mitigate the impact of market volatility, and achieve their long-term investment goals, even during times of market uncertainty. Of course, along with these potential benefits come additional complexities and risks. As a result, investors must understand the various strategies available to make more informed decisions about the role of alternatives in their portfolios. So, in this blog post, we will define alternative investment management and discuss its various types, examples, advantages, and disadvantages.
What are Alternative Investments?
A financial asset that does not fall into one of the traditional investment categories is known as an “alternative investment.” Alternative investments include private equity or venture capital, hedge funds, managed futures, art and antiques, commodities, and derivatives contracts. Real estate is frequently categorized as an alternative investment.
Understanding Alternative Investments
Most alternative investments are held by institutional investors or high-net-worth, accredited individuals because they are hard to understand, are not regulated, and have a high level of risk. When compared to mutual funds and exchange-traded funds (ETFs), the minimum investments and fees for many alternative investments are high. There are also fewer chances for these investments to publish performance data that can be checked and advertised to potential investors. Even though alternative assets may have high initial minimums and fees to invest upfront, transaction costs are usually lower than those of traditional assets because they aren’t traded as often.
Most alternative assets are fairly illiquid, especially compared to their conventional counterparts. For example, investors are less likely to be able to sell an 80-year-old bottle of wine than 1,000 shares of Apple Inc. because there aren’t as many people who want to buy old wine. Investors may have difficulty even valuing alternative investments since the assets and transactions involving them are often rare. For example, a seller of a 1933 Saint-Gaudens Double Eagle $20 gold coin might not know how much it’s worth because only 13 are known to exist and only one can be owned legally.
Who Can Buy Alternative Investments?
Buying many types of alternative investments has historically been limited to financially sophisticated investors like institutions or high-net-worth individuals deemed accredited investors by the Securities and Exchange Commission (SEC). This is because the majority of alternative investments are not traded on public markets and are typically not subject to SEC regulation.
If you want to buy alternative investments as an “accredited investor,” you must have made $200,000 or $300,000 a year for the past two years, have a net worth of $1 million or more, or show the SEC that you have “defined measures of professional knowledge, experience, or certifications.”
Types of Alternative Investments
#1. Hedge Funds
Hedge funds are private, pooled investment funds that use a number of risky investment strategies to try to get high returns. They can invest participants’ funds in almost anything, from publicly traded securities and derivatives to currencies, startups, and a wide range of other assets.
Most hedge funds are set up as private investment partnerships. The general partner is in charge of managing the portfolio and making decisions about investments. The fund’s mandate is the only real constraint on that person’s options.
#2. Private Equity Funds
Private equity funds are pooled investment vehicles that seek to acquire controlling stakes in public and private companies. They play an active role in the management of their portfolio companies, contributing both intellectual and financial capital.
When a private equity fund invests in a company, the goal is usually to restructure the company and give it money to speed up growth. When the fund liquidates its stake, it makes a profit, either by taking a portfolio company public in an initial public offering (IPO) or by selling it to another company.
#3. Venture Capital Funds
Venture capital funds provide capital to promising startups in exchange for equity. Like private equity firms, they may take an active role in the management and provide the necessary expertise.
However, venture capital investors tend to hold their investments for a longer period of time than private equity funds. They collaborate with the portfolio company and monitor progress, releasing funding rounds as certain benchmarks are met. they exit the investment after a merger, acquisition, or IPO.
#4. Fund of Funds
A fund of funds operates similarly to a hedge fund, but instead of investing in individual stocks, bonds, or other assets, it invests in other hedge funds. Because hedge funds typically have high minimum investment requirements, this strategy may provide investors with more options.
#5. Natural Resources
Commodities, farmland, and forests are examples of natural resources. For big companies, investing in commodities means buying barrels of oil or trainloads of iron ore to make other products. Commodities can be purchased by ordinary investors through derivatives such as futures and options. Farmland and forest investments provide alternative income streams based on the sale of trees, wood, and agricultural commodities.
#6. Real Estate
Real estate is the most accessible alternative investment because many Americans are already invested in this asset class through home ownership. Furthermore, real estate investing entails either purchasing physical property or purchasing funds that invest in real estate. Real estate investors anticipate capital appreciation over time, whereas real estate assets such as apartment buildings or shopping centers generate consistent rental income.
Alternative Investment Regulation
Alternative investments are vulnerable to investment scams and fraud due to a lack of regulations, even when they do not involve unique items such as coins or art.
Also, alternative investments frequently have a less clear legal structure than traditional investments. They are covered by the Dodd-Frank Wall Street Reform and Consumer Protection Act, and their practices are subject to scrutiny by the United States Securities and Exchange Commission. However, they are not usually required to register with the SEC. Because of this, the SEC does not watch over or regulate them as it does with mutual funds and ETFs.
As a result, when considering alternative investments, investors must conduct extensive due diligence. Alternative offerings may only be invested in by accredited investors in some cases. Accredited investors have a net worth of at least $1 million (not including their primary home) or an annual income of at least $200,000 (or $300,000 when combined with their spouse’s income). Financial professionals who hold FINRA Series 7, 65, or 82 licenses may also be considered accredited investors.
Read Also: Best 10 Real Estate Investment Software In 2023
What Are the Most Important Features of Alternative Investments?
The following characteristics set alternative investments apart from conventional forms of investment:
#1. Low correlation with traditional investments
Potential investors may greatly benefit from this because the low correlation allows for portfolio diversification.
#2. It is difficult to determine the underlying value.
Alternative investments are frequently inherently complicated when it comes to valuation. Alternative investment valuation may necessitate specialized knowledge, and some exotic investments, such as fine art, may exhibit unpredictable demand patterns. Furthermore, they may be unique in their nature, which complicates valuation.
#3. Relatively low liquidity
Alternative investments, in general, have low liquidity, especially when compared to traditional investments. The low liquidity can be explained by the absence of centralized markets and the low demand for some of the assets relative to traditional investments (think about works of contemporary art). In addition, some of the investments come with restrictions regarding exiting the investment.
#4. Exorbitant purchasing costs
Alternative investments are frequently associated with high purchasing costs. Some alternative investments, like hedge funds, have a minimum investment requirement as well as a fee.
What is an Alternative Investment Management?
The business of managing or advising on investment portfolios or individual assets for compensation is known as alternative investment management. These services are offered by banks and include both traditional investments (publicly traded stocks and bonds) and alternative investments.
Alternative Investment Example
Alt-funds are not necessarily safe investments just because they are regulated. The SEC observes that many alternative mutual funds have short performance histories.
Furthermore, while its diverse portfolio naturally reduces the risk of loss, an alternative fund is still subject to the inherent risks of its underlying assets. In fact, exchange-traded funds (ETFs) that focus on alternative assets have had a very erratic track record.
The SPDR Dow Jones Global Real Estate ETF, for example, had a five-year annualized return of 6.17% as of January 2022.
In contrast, the SPDR S&P Oil & Gas Exploration & Production ETF returned -6.40% over the same time period.
What Are the Benefits of Alternative Investments for Investors?
Alternative investments can keep their value even when the stock and bond markets go down because they don’t move in the same way. Also, hard assets such as gold, oil, and real estate are effective inflation hedges. For these reasons, many large institutions, such as pension funds and family offices, seek to diversify some of their holdings into alternative investment vehicles.
What Are the Alternative Investment Regulatory Standards?
Alternative investments are subject to less stringent regulations than more traditional securities. Alternative investment vehicles are subject to SEC regulation, but they are not required to register their securities. As a result, the vast majority of these investment vehicles are restricted to institutions or wealthy accredited investors.
Advantages of Alternative Investments
- There is little correlation. Low correlation with traditional asset classes is one of the most significant advantages of alternative investments. Commodities, for example, may perform well when the stock market is under pressure.
- Diversification. Because alternatives have a low correlation to stock or bond markets, including them in a portfolio can improve diversification.
- Less volatility. The impact of market volatility may be reduced because alternative investments are less exposed to broad markets.
- Inflation hedges. Some alternatives, such as gold, oil, or real estate, can be useful in mitigating inflation risk. Futures and options on commodities can also be used as a hedge against rising or falling prices.
- The possibility of higher returns. Alternative investments are riskier, but they also have the potential for higher returns.
Risks of alternative investments
- Absence of regulation. Alternative assets are not all regulated because they are not all registered with the SEC. However, they are subject to the Dodd-Frank Act, and the SEC may examine their practices.
- Absence of transparency. There are few to no public regulatory filings because most alternatives are not regulated by the SEC. As a result, investors face a lack of information.
- Limited liquidity. Because many alternatives are not publicly traded, it may be difficult to buy or sell these investments. Many hedge funds and private equity funds may have lockups that bind investors to a specific period of investment during which there are no redemptions permitted.
- Difficult to value. It may be difficult to determine the value of alternative investments in the absence of a market price. Valuations can differ greatly depending on the appraiser and are more susceptible to subjectivity.
- Exorbitant minimum investments. Alternatives are not structured with the average investor in mind so minimum investment requirements can be prohibitively high.
- Increased dangers. Higher risk comes with the potential for high returns. Many alternative investments may involve risky strategies such as short selling or complex derivative trading.
How to Invest in Alternative Investments
Purchasing alternative investments present more challenges than investing in conventional asset classes. While the prospect of higher returns and greater diversification may be enticing, the risk is proportional. You’ll need to do a lot of research and due diligence if you’re thinking about making an alternative investment.
Access to alternative assets may be limited for those who are not accredited investors. However, many alternative investment funds and exchange-traded funds (ETFs) are available today, though many are expensive.
Consider the Invesco Global Listed Private Equity ETF (PSP). This ETF invests in well-known private equity funds. With an expense ratio of 1.44%, the fund isn’t cheap, but if you’re not an accredited investor, that’s what you pay to gain exposure to this type of alternative asset strategy.
Since these funds are publicly traded instruments, they are registered with and regulated by the SEC, making them safer choices for unaccredited investors. Morningstar can help you identify available funds and ETFs, but the best way to invest in alternatives is to work closely with a financial advisor, who can suggest the best options to help you achieve your goals.
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