Key Points
- Alternative investments cover various asset types and strategies.
- Investors are looking at alternative investments because of high interest rates.
- Historically for high-net-worth individuals because of their complexity.
A unique confluence of steadily rising interest rates and soaring inflation has resulted in a historically challenging environment in which diversification — often considered the bedrock of investment strategy — is offering little solace.
The time, therefore, might be ripe for investors to look beyond the traditional stock and bond dichotomy. Alternative investments offer another avenue for diversification, risk mitigation and, most importantly, the prospect of enhanced returns in an increasingly uncertain market.
What are alternative investments?
The term alternative investments is broad and covers various asset types and strategies. To simplify the concept, it’s easier to define alternative investments by what they are not.
“Typically, any asset class outside of stocks, bonds and cash is referred to as an alternative asset,” says Robert Johnson, professor of finance at Creighton University’s Heider College of Business. “The most popular types of alternative assets include hedge funds, private equity, commodities and real estate.”
Unlike traditional long-only assets — where “long” means to buy with the expectation of price appreciation — such as stocks, bonds and cash, alternative investments exist outside this conventional paradigm.
By venturing outside the conventional boundaries of stocks, bonds and cash, investors can access opportunities uncorrelated to traditional markets, potentially safeguarding their portfolios from the widespread declines seen in traditional asset classes.
“Investors may be drawn to alternatives if they have significant capital in traditional asset classes in hopes of either lowering portfolio risk or increasing alpha,” says Curtis Congdon, president at XML Financial Group.
Historically, alternative investments have been the domain of institutional investors and high-net-worth individuals due to their complexity, illiquidity and higher costs. However, their appeal for diversification and risk mitigation, particularly in turbulent market conditions like those of 2022, is making them increasingly attractive to a broader range of investors.
Types of alternative investments
The varied nature of alternative investments means investors have an expanded range of choices beyond the traditional asset classes. Here’s an overview of some principal types of alternative investments, although it’s worth noting that this list is far from exhaustive.
1. Private equity
Private equity involves investing in companies that are not publicly traded on a stock exchange. This investment often requires a longer-term commitment and involves higher risks but can offer substantial returns. Private equity investments can range from venture capital for startups to leveraged buyouts from established companies.
2. Hedge funds
Hedge funds are pooled investment funds that use various strategies to generate returns for their investors.
Unlike mutual funds, hedge funds often employ more complex trading activities, including short selling, leverage and derivatives. Due to the complexity and risk associated with these funds, they are typically open only to accredited investors, such as institutions or high-net-worth individuals. They also charge higher management and performance fees compared to regular mutual funds.
3. Real estate
Investing in real estate involves the purchase of physical, commercial or residential properties, either directly or indirectly, through publicly-listed real estate investment trusts. Real estate can serve as a hedge against inflation and offers the potential for income through rent and capital appreciation.
4. Commodities
Commodity investing involves trading raw resources and materials that include precious metals like gold, energy inputs like oil and agricultural products like wheat. Investors can get exposure to commodities through various means, including futures contracts and exchange-traded funds . Commodities can be volatile but offer diversification benefits and can be a potent inflation hedge.
5. Collectibles
Collectibles include tangible assets like fine art, liquor, antiques and vehicles. While they might not generate income in the traditional sense, their value can be appreciated over time and they can offer aesthetic or emotional satisfaction. However, the market for these assets can be illiquid and subject to a lower degree of regulation.
6. Cryptocurrencies
Cryptocurrencies like bitcoin, ethereum and dogecoin are digital or virtual currencies that use the blockchain, a decentralized ledger for security and transactions. Highly volatile, less regulated, but increasingly popular, cryptocurrencies offer a new frontier for those interested in virtual alternative investments.
7. Peer-to-peer lending
Also known as P2P lending, this involves lending money to individuals or small businesses online through platforms that match lenders with borrowers. While not without risks, P2P lending can offer attractive yields, often higher than traditional bonds or certificates of deposit.
What is an alternative investment fund (AIF)?
An alternative investment fund is a specialized investment vehicle that offers exposure to various alternative investment strategies and asset classes.
These funds can be structured in various forms, such as hedge funds, mutual funds or ETFs. They can invest in a broad range of assets including, but not limited to, stocks, bonds, commodities, currencies and derivatives like futures, swaps and options. Several common strategies employed by AIFs that may employ one or a combination of these assets include:
- Global macro: This strategy seeks to profit from changes in global economies, typically by employing a variety of instruments such as bonds, stocks and currencies. Fund managers make directional bets on macroeconomic trends such as interest rates, political events and commerce.
- Long-short: In this strategy, the fund takes long positions in stocks expected to appreciate and short positions in stocks expected to decline, aiming to profit from upward and downward market movements.
- Market neutral: This strategy aims to exploit inefficiencies by taking long and short positions in different stocks within the same sector, thereby minimizing exposure to broad market movements.
- Trend-following: This strategy attempts to capture gains by analyzing an asset’s momentum in a particular direction. Fund managers use various signals like moving averages to determine the trend.
- Event-driven: This is an additional strategy where the fund seeks to profit from significant corporate transactions like mergers, acquisitions or bankruptcies, which can cause the price of a company’s stock to experience significant volatility.
Depending on the structure of the alternative investment fund, accessibility may vary. Hedge funds, often structured as limited partnerships, are generally accessible only to accredited investors due to their complexity and risk profile. On the other hand, alternative mutual funds and ETFs are typically available to retail investors as they are regulated more similarly to their traditional counterparts.
“Alternatives were initially regarded as an odd fit for ETFs, but investors have since grown to see the potential benefits of lower fees, greater transparency, increased liquidity and individual tax basis,” Congdon says. Examples of popular alternative ETFs include the iMGP DBi Managed Futures Strategy ETF (DBMF) and the KFA Mount Lucas Managed Futures Index Strategy ETF (KMLM).
Fee structures can also differ substantially. Most hedge funds follow the “2 and 20” model, charging a 2% annual fee on the total asset value and a 20% performance fee on any gains generated. Mutual funds and ETFs may have a flat annual management fee that is more straightforward but can vary in amount.
Related: Masterworks review 2023.
Pros and cons of alternative investments
As investors grapple with a financial landscape punctuated by market volatility and economic uncertainties, the allure of alternative investments becomes increasingly potent.
However, like all investment options, alternative assets have advantages and disadvantages that must be carefully weighed.
Pros:
- Potential for positive absolute returns: One of the most attractive features of alternative investments is their potential to deliver positive absolute returns irrespective of market conditions. Unlike traditional long-only investments, which often depend on a bullish market for gains, many alternative investment strategies aim for a positive return regardless of broader market performance.
- Potential for uncorrelated returns: Alternative investments often move independently of stocks and bonds, providing valuable diversification benefits. By adding assets that are uncorrelated with traditional markets, investors can reduce the overall risk profile of their portfolio.
- Potential for crisis alpha: Crisis alpha refers to the potential for alternative investments to perform well during market downturns, thus providing a hedge against market risk. In a well-diversified portfolio, the inclusion of assets with crisis alpha can serve as a financial bulwark, helping to preserve capital when traditional markets are in turmoil.
Cons:
- High fees: Alternative investments are often accompanied by a higher fee structure, especially in the case of hedge funds, which typically charge both a management fee and a performance fee. These costs can erode returns and pose a significant barrier to entry for some investors.
- Lack of liquidity: Many alternative investments, such as real estate and private equity, lack the liquidity of traditional stocks and bonds. This means investors might find it challenging to quickly convert these assets into cash without incurring significant costs, which can be problematic in times of financial need.
- Single manager risk: The performance of alternative investments often hinges on the skill and expertise of the fund manager. Unlike traditional investments, where index funds can offer an average baseline level of performance, the unique strategies employed by alternative investment managers can result in a wide range of outcomes, adding a layer of risk.
How do alternative investments fit into a portfolio?
The inclusion of alternative investments in a portfolio is fundamentally an exercise in asset allocation tailored to an individual’s financial objectives, risk tolerance and investment horizon.
Traditional approaches like the 60/40 portfolio of equities and fixed income are being increasingly scrutinized, particularly in the wake of economic conditions that have led to synchronized downturns in both asset classes.
As a result, some investment experts are advocating for more diversified portfolio structures, such as the “40/30/30” model: 40% in equities, 30% in fixed income, and 30% in alternative investments.
The precise makeup of the 30% allocation to alternative assets is subject to individual preferences and needs. For those seeking liquidity — i.e., the ability to easily convert assets into cash — options like alternative mutual funds, ETFs, cryptocurrencies and commodities futures could be more suitable. These investments offer the diversification benefits of alternatives but are generally easier to sell on short notice.
On the other hand, illiquid alternatives such as hedge funds, art, private equity, private credit, real property or peer-to-peer lending may be more fitting for those with a longer investment horizon and a higher threshold for risk. These investment types often require a more extended time commitment but can offer the potential for higher returns and further diversification benefits.
Tip: Incorporating alternative investments into a portfolio necessitates a thorough understanding of the assets themselves and the investor’s financial profile. When thoughtfully integrated, alternative investments can act as a counterbalance to traditional assets, offering both risk mitigation and opportunities for enhanced returns.
However, the risk profile, fee structure and liquidity constraints of these alternative assets should be carefully considered within the larger context of one’s investment strategy and financial goals.
Frequently asked questions (FAQs)
Determining whether alternative investments are worth it is a nuanced question that varies from investor to investor, rooted in individual financial objectives, risk tolerance and investment horizons. These investments are not one-size-fits-all. It also depends on the particular strategy or asset the alternative investment focuses on and how it pertains to your circumstances.
For instance, an investor with a portfolio already diversified in stocks and bonds seeking an additional layer of diversification without sacrificing liquidity might find an alternative ETF a suitable choice. These liquid alternatives can further insulate a portfolio from market volatility while offering relatively easier exit strategies.
Conversely, an investor with a higher tolerance for risk, a long-term perspective and comfort with having capital locked up for an extended period might find private equity a compelling investment. But while the potential for high returns in private equity can be alluring, it comes with increased risks and usually higher fees.
It’s worth asking: can your investment objectives be met by traditional assets without venturing into the complexities and higher fees often associated with alternative investments? If the answer is yes, then the necessity of including alternative investments in your portfolio might be less urgent.
Yes, private debt is considered an alternative investment. Unlike publicly traded bonds or traditional fixed-income securities, private debt comprises loans or debt securities that are not publicly traded.
These financial instruments can include direct loans to companies, mezzanine financing, distressed debt and other forms of specialized lending. Typically, private debt offers investors the opportunity to earn higher yields than traditional bonds, but it also has downsides.
Investing in private debt often involves more complex structures and more due diligence. As these loans are not easily traded on public markets, the lack of liquidity is a key consideration for investors. Private debt also usually requires a longer investment horizon, as these loans may have several years of maturities.
“Potentially higher returns and a lower correlation with stocks and bonds are provided as a rationale for investing in alternative assets,” Johnson says. “In the early 2000s, with the success of the ‘Yale model’ of investing popularized by investment guru David Swensen, more and more institutional investors flocked to alternative assets.”
However, the question of why one should invest in alternative investments can be more effectively addressed by posing a series of follow-up questions:
- Am I looking for diversification or different sources of risk and return?
If you’re seeking to diversify your portfolio beyond the confines of traditional asset classes like stocks and bonds, or if you’re chasing different sources of risk and return, alternative investments could be a fitting addition. They can hedge against market volatility and offer new avenues for potential profit. - Am I comfortable with paying higher fees?
Alternative investments often come with higher management and performance fees. If you’re willing to absorb these additional costs in pursuit of the advantages that alternatives can provide — such as diversification and the potential for higher returns — then they may be worth considering. - Do I fully understand the complexity?
Alternative investments can be intricate, involving nuanced strategies and a higher degree of risk. Thorough due diligence is imperative to grasp your chosen alternative asset’s idiosyncrasies and potential downsides. If you’re comfortable navigating this complexity or willing to engage experts who can, alternatives may be viable. - Am I okay with lower liquidity?
The illiquidity of many alternative investments means you may need more time to sell your asset at market value on short notice. If you have a longer investment horizon and can tolerate this lack of liquidity, alternatives can be a fruitful component of your investment strategy.
By carefully pondering these questions, you can gauge the appropriateness of alternative investments for your portfolio. An honest appraisal of your investment goals, risk tolerance and understanding of these unique assets will help clarify whether they align with your financial objectives.
