If you’re an investor looking to diversify your portfolio with alternative investments, you’re in the right place. In this post, we’ll outline the key characteristics of alternative investments, including the benefits and effective strategies to help you get started diversifying your portfolio.
What Are Alternative Investments?
Alternative investments allow investors to minimize their risk and diversify their portfolios by seeking investments outside of the conventional stock market. Examples of alternative investments include real estate, hedge funds, venture capital, commodities and private debt. We’ll go over these popular categories in more detail below.
Alternative investors in real estate often invest in office buildings, shopping malls, storage units and residential apartments and condos. Investors who don’t want the hassle of playing landlord opt for crowdfunding real estate investments which allow them to reap the benefits of growth without having to worry about rent being paid on time, the broken pipes in 24A, or the fighting couple in 9B.
Similar to other real assets, valuation is challenging in real estate investing. Valuation methods include:
- Income capitalization.
- Sales comparable.
- Discounted cash flow.
Private equity investors invest their money in companies that are not publicly traded. The downfall of this alternative investment is that investors may not have access to their cash for as long as ten years.
Venture capital is a subset of private equity and is the process of investing in early-stage companies or startups that have great potential for growth or those that are expanding rapidly in new or innovative spaces. The downfall with this alternative investment is that it’s a rather high-risk investment and comes with a high chance of failure because a lot of the companies don’t have revenue or profits at the time of the initial investment. Of course, if the company succeeds, it comes with a high reward for the investor.
Private debt is a term that refers to any investment that is not financed by banks or traded on an open market. It’s typically leveraged when businesses need additional funding to grow. Companies that issue this type of capital are called private debt funds. They make money in two ways:
- Interest payments.
- Repayment of the initial loan.
Private debt, which is also referred to as private credit, presents a chance for investors to potentially gain higher yields compared to public market offerings. Types of private debt include mezzanine and senior debt, which are both considered higher on the payout structure in cases dealing with default and are therefore considered less risky. The riskier investment in this asset class is in distressed credit, in which people invest in the debt of companies under stress — as the name suggests.
This type of investment fund trades assets that are relatively liquid and deploys multiple investing strategies to earn a high return on investment. It’s important to note that hedge funds are exclusive and are only available to institutional investors, including people with high-net-worths, pension funds, mutual funds and endowments.
One common hedge fund investment strategy is known as long-short equity, in which managers invest in a company with the potential to appreciate. But, they might also decide to sell short, betting against the company and would therefore profit if and when the company’s value decreases.
Hedge funds also deploy absolute return strategies, which are also called “all-weather strategies.” This strategy invests in a broad spectrum of asset classes and strategies to generate returns despite how conventional markets are performing.
A third common hedge fund strategy is called market neutral. Market-neutral funds aim to lower the systematic risk that’s created by factors like investment styles, currencies, exposures to sectors and market-cap ranges.
Crude oil, corn, coffee, and other agriculture and natural resources make up the commodities asset class. Since these assets are real, they are commonly considered inflation hedges. This type of trade takes place in the futures market. It’s important that commodities investors sell the contract before maturity and then purchase a new one to hold their position. The new contract may be more expensive than the old one, a common performance drag with this alternative investment option. Some commodities are also available via ETFs, including gold and oil.
Did you know that commodities have been traded for thousands of years? Amsterdam and Osaka, Japan both claim to have founded the earliest formal commodities exchange, dating back to the 16th and 17th centuries! It took until the mid-19th century until the Chicago Board of Trade started trading commodity futures in the United States.
From rare wines to vintage cars and Jackie Robinson’s baseball card, when you invest in collectibles, you purchase unique and valuable physical items with hopes their value will continue to appreciate over time. Although this is no doubt a fun and even glamorous type of investing to get into, it’s also quite risky because of the high costs to acquire the goods, lack of dividends and other income until you sell the items and the potential for the items to get damaged, lost or stolen.
Key Characteristics of Alternative Investments
As you can tell, alternative investments span a vast array of assets and strategies. But, in general, most alternative investments are characterized by the following:
- Low correlation to conventional investments, such as stocks, cash, and bonds. Alternative investments don’t move the same way as the market conditions; some even perform better when the market drops.
- Higher minimum investment is required typically.
- Greater potential for returns than conventional investments.
- Assets are more illiquid.
- Shares and/or interest gains cannot be redeemed or sold as needed, often take years to become liquid.
- Investment structures and risk-return profiles are often complicated.
- The risk profile is extremely unique and must be fully understood by investors before they invest.
- Exposure to unique markets and investment opportunities they otherwise would not have had access to, such as the chance to be an early investor in an innovative startup, which can lead to large returns down the road.
- They are not regulated by the U.S. Securities and Exchange Commission (SEC).
The two main reasons to invest in alternative investments are portfolio diversification and enhanced returns. Of course, any investment should be well-researched and carefully considered. Remember, alternative investments are illiquid for a while and are therefore not suited for day traders or people looking to get rich quick. But, for patient investors, alternative investments are well worth the wait.