The year 2020 was hardly a good one for traditional stock and bond markets. With unpredictability and volatility running high, investors began to show interest in alternative investments.
An alternative investment is an investment in assets different from stocks, bonds and cash — savings deposits, CDs, money market deposit accounts, treasury bills and money market funds. These can be investments in financial assets such as hedge funds, distressed securities and private equity, or tangible assets such as fine art and collectibles.
Alternative investments tend to show a low correlation with traditional investments. Many offer significantly greater returns than traditional investments. Add to this their wide range of choices and they make a great addition to any investor’s portfolio.
The investor universe is evolving. More and more people are turning to alternative investments to provide diversification from traditional investments, boost returns and achieve their goals.
Alternative versus conventional investments
Unlike their conventional counterparts, alternative investments:
- Difficult to determine their underlying value;
- Have low correlation with traditional investments;
- High purchasing costs;
- Relatively low liquidity.
Are alternative investments for everyone?
Many alternative investments are becoming increasingly mainstream. Some, however, are highly illiquid and come with extremely complicated valuations. Often, investors may be required to lock up their money for five or even ten years, which makes these investments popular among high-net-worth individuals and financial institutions.
These investors typically fall into two groups: qualified purchasers and accredited investors. Qualified purchasers are considered sophisticated investors with a $5 million-plus investment portfolio, individually or jointly.
Accredited investors, on the other hand, must have an individual or joint net worth exceeding $1 million, or individual income exceeding $200,000 ($300,000 for joint income) for the last two years. They also must expect their earnings to continue at this level.
Alternative investment options for asset diversification
- Private equity. This refers to debt and equity positions in enterprises that are not publicly traded. Private equity investments typically come from funding new ventures, distressed debt brought about by the decline in the health of previously healthy firms, and from the equity of leveraged buyouts (LBO) of existing businesses.
Investors’ money can be inaccessible for as long as 10 years as they wait for the private equity fund to sell to a strategic buyer or sell the holdings in an Initial Public Offering (IPO).
- Venture capital. As a sub-category of private equity, venture capital involves investing in startups with the potential for outsized growth, or in early-stage companies looking to expand rapidly in a new or innovative space.
Since many of these companies may not yet have revenues or profits, they have a high chance of failure. That said, if a firm succeeds, there’s great reward for its investors.
- Art, valuables, and collectibles. Examples of what can be called a collectible are virtually endless. People will seek out, treasure, and stockpile just about anything.
A collectible’s value comes from its age and rarity. Some collectibles – like paintings, fine wine, or aged alcohol – are quite traditional and can only be accessed by exclusive investor circles.
Alternatives that are available to a wider audience include designer sneakers and baseball cards. Most of these items can be owned outright in physical form, which requires some care and protection. However, it’s also possible to fractionally own any of the collectibles.
This asset class has unpredictable returns with somewhat tough average appreciation.
- Hedge funds. Hedge funds refer to a privately organized investment vehicle that utilizes its less regulated nature to offer investment opportunities significantly distinct from those offered by traditional investment vehicles.
While hedge funds operate mainly in public markets, they use less traditional tools, such as short-selling and leverage, to generate absolute returns regardless of the market environment.
- Cryptocurrency. Cryptocurrency is a hot and volatile asset class with relatively easy entry.
Instead of relying on brokers or other third parties, you can easily operate and hold the assets in a personally protected virtual wallet. Cryptos provide users a medium to transact online and in the real world securely and anonymously. They allow for both trading and passive buy-and-hold strategies.
- Real estate. When people buy investment property, such as residential apartments or office buildings, and hold on to them as a long-term investment strategy, it’s considered a traditional alternative asset class.
Real estate value, especially in areas with high property demand, can net you gains that go beyond what you’d get on Wall Street. The biggest downsides of real estate as an investment option are the huge upfront costs and relatively low liquidity. Thankfully, property ownership isn’t the only way that investors can get into real estate.
Real Estate Investment Trusts (REITs) are highly liquid modern alternative investment options in the real estate market. It’s now possible to invest in different real estate projects without the headache of being a landlord or developer. REITs allow you to own fractions of a property that’s managed through a trust. You receive interest once the property is developed.
- Private debt. Just as some companies look to private equity for funding, some also tap private lenders.
Also called private credit, private debt is another great opportunity for investors to feasibly get higher returns compared to what’s available in public markets. The most common types of private debt are mezzanine and senior debt.
Most investors access alternative assets through an institution or their financial advisor. Thanks to technology, however, digital platforms have started offering ways to buy directly. If you’re a new investor, it’s still advisable to invest with a registered investment advisor who understands the various asset classes, their benefits and their challenges.