What Are Alternative Investments?
When it comes to investing, you’re likely familiar with stocks and bonds, but there’s a whole universe of possibility outside these traditional asset classes. Alternative assets, from hedge funds and private equity to venture capital and rare collectables, allow investors to further diversify their holdings and pursue returns less correlated with the stock market.
What Is an Alternative Investment?
An alternative investment is a financial asset that doesn’t fall into conventional asset categories, like stocks, bonds and cash.
Alternative investments include private equity, venture capital, hedge funds, managed futures and collectables like art and antiques. Commodities and real estate can also be classified as alternative investments.
Who Can Buy Alternative Investments?
Buying many types of alternative assets 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 most alternative investments are not traded on public markets, and they’re typically unregulated by the SEC.
If you wish to purchase alternative investments as an accredited investor, you can qualify in a few different ways: by having an annual income of $200,000—$300,000 for a couple—for the past two years; by maintaining a net worth of $1 million dollars or more; or by demonstrating “defined measures of professional knowledge, experience, or certifications” in the SEC’s eyes.
Types of Alternative Investments
Hedge funds are private, pooled investment funds that seek high returns through varied and often risky investing strategies. They can put participants’ money in just about anything, from publicly traded securities and derivatives to currencies, startups or myriad other assets.
Hedge funds are typically organized as private investment partnerships in which the general partner manages the portfolio and makes investment decisions. That person’s choices are only really limited by the fund’s chosen mandate.
Private Equity Funds
Private equity funds are pooled investment vehicles that aim to acquire controlling stakes in private and public companies. They take an active role in managing their portfolio companies, providing intellectual and financial capital.
When a private equity fund acquires a stake in a company, the goal is usually to restructure the firm and provide capital to accelerate growth. The fund turns a profit when it liquidates its stake, either by taking a portfolio company public in an initial public offering (IPO) or by selling it off to another company.
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 management and lend necessary expertise.
However, venture capital investors tend to stay invested longer than private equity funds. They work with the portfolio company and monitor progress, releasing rounds of funding as certain benchmarks are met. They exit the investment following a merger, acquisition or IPO.
Fund of Funds
A fund of funds operates much like a hedge fund but invests in other hedge funds rather than individual stocks, bonds or other assets. Hedge funds typically have high minimum investment requirements, so this approach can broaden access for investors.
Natural resources include commodities, farmland and forests. For big companies, investing in commodities means buying barrels of oil or trainloads of iron ore to make other products. Regular investors can invest in commodities via derivatives like futures and options. Investing in forests and farmland offers alternative investors income streams based on the sale of trees, wood and agricultural commodity prices.
Real estate is the most accessible alternative investment—many Americans are already invested in this asset class by owning their homes. Real estate investing means purchasing actual property or buying funds that invest in real estate. Real estate investors anticipate appreciation in value over time, while real estate assets like apartment buildings or shopping centers generate steady rental income.
Advantages of Alternative Investments
- Low correlation. One of the greatest advantages that alternative investments offer is low correlation with traditional asset classes. When the stock market is under pressure, commodities, for example, could very well be performing well.
- Diversification. Thanks to low correlation to stock or bond markets, including alternatives in a portfolio can improve diversification.
- Lower volatility. Since alternative investments are less exposed to broad market, the impact of market volatility can be lower.
- Inflation hedges. Some types of alternatives, such as gold, oil or real estate, can be effective in hedging inflation risk. Commodity futures and options can also be used to hedge against rising or falling prices.
- Potentially higher returns. Since alternative investments entail a higher level of risk, they also offer the potential for higher returns.
Risks of alternative investments
- Lack of regulation. Not all alternative assets are registered with the SEC, and therefore are not regulated. However, they do fall under the purview of the Dodd-Frank Act and therefore their practices may be reviewed by the SEC.
- Lack of transparency. Since most alternatives are not regulated by the SEC, there are few to no public regulatory filings. This results in a dearth of information for investors.
- Low 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 commit investors to a defined period of investment during which redemptions are not possible.
- Difficult to value. In the absence of a market price, it may be challenging to determine the value of alternative investments. Valuations may vary widely depending upon the appraiser and are more vulnerable to subjectivity.
- High minimum investments. Alternatives are not structured with the average investor in mind, so minimum investment requirements can be prohibitively high.
- Greater risks. With the potential for high returns comes higher risk. Many alternative investments may involve risky strategies like short selling or trading complex derivatives.
How to Buy Alternative Investments
Buying alternative investments entails bigger challenges than sticking to traditional asset classes. While the potential for higher returns and greater diversification can be alluring, the risk is proportional. If you’re considering alternative investments, you’ll need to perform extensive due diligence and research.
For those who aren’t accredited investors, access to alternative assets may be limited. However, today there are many alternative investment mutual funds and exchange-traded funds (ETFs) available, though many come at a high price.
Take the Invesco Global Listed Private Equity ETF (PSP), for example. This ETF buys stakes in high-profile 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 the price you pay to get exposure to this kind of alternative asset strategy.
Since these funds are publicly traded instruments, they’re registered with and regulated by the SEC, which can make them safer choices for unaccredited investors. Sources such as 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.