What Are Alternative Investments?
Alternative investments have different features from traditional assets, such as stocks or bonds. Find out how they work in this article.
Stocks, index funds, and bonds are often the first investments to pop into our minds when we think of ways to invest our money. However, there are various types of assets, each with unique rewards, risks, and behavior. One is alternative investments, which refers to a set of assets that often follow a different trajectory from other securities.
In this article, we’ll define alternative investments and break down several of the most common types. We’ll also outline the pros and cons of the overall category and answer some frequently asked questions.
Overview of Alternative Investments
Alternative investments refer to a broad category of securities that deviate from traditional assets such as stocks, bonds, and cash. This could include anything from real estate, commodities, and hedge funds to collectibles such as art or classic cars. In general, these assets are primarily accessible to high-net-worth or institutional investors, often requiring more money to invest.
“If there are conventional investment vehicles, it stands to reason there would be unconventional or alternative investments available as well,” says Todd Shaffer, Senior Manager of Research at VectorVest. “Alternative investments are any financial assets that do not fall into one of the conventional investment categories of stocks, bonds, and cash,” he says.
Alternatives are often difficult to sell and, in many cases, perform differently than conventional assets. However, due to their distinct performance from traditional assets, it’s common for investors and investment managers to use them when building a diverse portfolio. And, though they’re often reserved for investors with more resources, many alternatives, including real estate and commodities, are available to average investors by way of mutual funds or ETFs.
“For investors looking for diversification, investing in truly non-correlated investments is critical,” says Gary Quinzel, CFP, CFA, and Vice President of Portfolio Consulting at Wealth Enhancement Group. He continues, “2022 was a great example of why this is important, as stocks and bonds took losses simultaneously. We look for investment strategies unrelated to the same factors, such as interest rates or inflation. Still, we are driven by differentiated factors and have historically low correlations to public markets.”
Types of Alternative Investments
What falls under the category of an alternative investment can vary. Below are commonly recognized types of alternative investments:
Real estate involves owning residential or commercial property. If you own a home, you technically already have real estate in your portfolio. Then, to eventually get a return on it, you can sell it for more than you purchased it for. However, more commonly, investors will buy a property to generate income, often by renting it to tenants.
Another way to add real estate to your collection is via passive options, such as real estate investment trusts (REITs) or mutual funds. This allows you to indirectly own shares of a commercial property or a set of them.
Commodities are assets that have tangible value, such as precious metals, agriculture, and oil. Securities in this category derive their value from supply and demand. More specifically, their prices often rise or fall because of outside factors, such as weather, geopolitical events, or practical use across industries.
In general, people tend to invest in commodities as a means of diversification. For example, as equities suffer during times of economic hardship, commodities such as gold or oil may gain value. This is because they hold unquestioned value in the real world, while the value of stocks often hinges on a company’s or a set of companies’ performance.
Another reason investors add commodities to their portfolios is because they act as a hedge against inflation. As the value of your dollars decreases during periods of inflation, the value of these assets may stay the same or increase as they become more in demand.
Also known as venture capital, private equity involves investing in privately held companies in exchange for equity. This falls under the alternative investment umbrella because it tends to require putting up far more capital than buying shares in a company publicly traded on the New York Stock Exchange (NYSE) or Nasdaq. And, in many cases, it’s not as passive. Investors sometimes spend time aiding the founders or leadership team with the direction of the company, especially if they’re acquiring a significant stake or a complete buyout.
Hedge funds are pooled investments that aim to gain substantial returns by investing in alternative securities. They’re typically only available to accredited investors, such as high-net-worth individuals or institutions. Hedge funds are alternatives because they tend to include non-traditional assets, have less regulation, and require a certain level of wealth to participate.
Because they tend to have subjective value and, often, rare quality, collectibles earn the alternative label. They can also be fairly common, as some people may even have them without knowing or could get them by chance, such as an athlete signing a ball. Common examples include fine wine collections, sports memorabilia (e.g., baseball cards, autographed jerseys and helmets, championship rings, etc.), movie props, toys, and artwork.
Earning significant exposure in recent years, cryptocurrency involves investing money in digital coins, such as Bitcoin. Its speculative, volatile nature and different performance than traditional investments give it the alternative classification.
Unlike many of the others on this list, crypto has the benefit of being generally accessible to average investors. Although it can be expensive to buy in large quantities, investors can add it to their portfolio using various platforms. Collin Plume, founder and CEO of Noble Gold Investments, says, “With [cryptocurrency]…you can open an account now and finalize your investment the same day.”
Pros and Cons of Alternative Investments
Alternative investments can be effective as you try to build a layer of diversity in your portfolio. However, they can be tough to get into and may require you to have a lot of resources to buy them.
Below is a list of the pros and cons of these types of investments:
- Effective for diversification. They often perform and receive their value differently from assets such as stocks and bonds. Per Plume, this means that “[when] a recession or any kind of economic downturn hits, you know you have assets you can still turn to.”
- Ability to produce high returns. Alternatives, such as real estate, can often generate large returns because of their high value or rarity.
- Tangible value. Many of these investments, particularly commodities, hold real-life value. During economic turmoil, therefore, their value may remain the same or even increase due to demand.
- A higher barrier to entry. Many alternative investments require you to have a high net worth before adding them to your portfolio. Hedge funds, for instance, are typically only for wealthy or institutional investors.
- Lower regulatory standards. Various non-traditional assets, like collectibles, may not fall under the jurisdiction of state regulatory agencies or federal organizations such as the U.S. Securities and Exchange Commission (SEC).
- Volatility. “Many of these alternative assets are volatile like cryptocurrencies, private equity stakes, and private debts. They offer possibilities of incredible gains but you could lose all your investments fast,” Plume explains.
- More complex. Unlike stocks or bonds, which have libraries of educational information about them, some alternatives may be complex or somewhat new. A prominent example of this is cryptocurrency.
- Harder to value and sell. While some have practical uses, giving them intrinsic value, others may have more subjective qualities. Because of their difficulty to value or high price, it can be challenging to find a buyer for these types of assets.
Frequently Asked Questions
Why are alternative assets illiquid?
Illiquidity is one of the most commonly cited drawbacks of these assets. As noted, they’re sometimes difficult to appraise and can carry immense value, which could make it hard to find a suitable buyer at the right time.
While alternatives can provide returns even during periods where your traditional assets appear on the downswing, Christopher J. Day, founder and CEO at Days Global Advisors, notes that they can require longer holding periods before you can reap those returns. He says, “They’re usually illiquid because to get the uncorrelated return you typically have to invest longer term on the investment time horizon.”
Who should invest in alternatives?
Alternative investments can tend to be inaccessible to average people, both because of their complexity and often high cost. However, Quinzel observes that this has shifted over time. “It used to be that only institutions and the ultra-wealthy were ideal candidates for alternatives, but this has dramatically changed in recent years,” he explains. “The products are improving as the industry has become democratized, so anyone with a longer time horizon and limited near-term liquidity needs should consider alternatives based on their circumstances.”
So, who is the ideal type of investor for alternatives? Quinzel says that “the ideal investor is an educated investor, and it is our job as advisors to explain the pros and cons of more complex investments.”
Are there financial professionals who specialize in alternative investments?
The primary type of professional that can help with investing in alternatives is chartered alternative investment analysts (CAIAs). Individuals with this designation have rigorous training and wide-ranging expertise on the advantages and disadvantages of these assets, as well as how they may fit into your portfolio.
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