Introduction to Alternative Investments
“Alternative investments” is an umbrella term for the group of investments that fall outside of the traditional asset classes such as stocks, bonds, or cash investments. Because these assets are not tied to traditional markets, these assets may be less liquid than traditional assets and may require a longer investment period before any return is realized.
Traditional investments refer to long-only positions in stocks, bonds, and cash. All other investments are classified as alternative investments.
Traditional vs. Alternative Investments
Traditional investments are publicly traded investments in stocks, bonds, or cash. The most common method of investing is using public markets where corporations sell shares to the public via stock exchanges such as the FTSE and NYSE. These investments are more uniformly regulated by financial authorities such as the Securities Exchange Commission (SEC).
Alternative investments, on the other hand, refer to all investments that do not fall into the three traditional investment categories. These investments are generally more complex. For those reasons, alternatives have historically been held by institutional or accredited investors.
|Traditional Investments||Alternative Investments|
|Highly correlated with, and sensitive to market movements||Low correlation to public markets|
|Low investment minimums||Often high minimum investments|
|Open to general public||Not always open to general public|
Types of Alternative Investments
Real estate is the world’s most common and largest asset class. Unlike other alternatives, real estate investments share some characteristics with fixed income and equity investments. Similar to the payment structure of bonds, property owners receive current cash flow from tenets paying rent. Like equity, the goal of real estate investing is to increase the long-term value of the asset, or capital appreciation.
Commodities are a real asset, same as real estate, mostly referring to natural resources. Agricultural products, oil, natural gas, and precious metals are all examples of commodities. Commodities are considered a hedge against inflation, as they are not reactive to public equity markets.
The value of commodities rises and falls with supply and demand, so higher demand for commodities results in higher prices and vice versa.
According to the 2022 Art Basel and UBS Art Market Report, 61% of high-net-worth collectors report allocating over 10% of their portfolios to art. Fine art is a popular asset for these investors likely for its favorable investment characteristics. Fine art differs from traditional assets and other alternatives for its ability to act as a store of wealth to hedge against inflation and currency devaluation.
Art, particularly contemporary and blue-chip art, has a low correlation with stocks and bonds, offering a diversification for portfolios. Based on a Citi report, art has a 0.09 correlation with developed market equities and a -0.08 correlation with investment-grade bonds.
Art also is seen as valuable based on its cultural reception. Art can be a passion investment, an investment vehicle chosen not only for its diversification and capital appreciation features but also for its beauty and cultural value.
Outside of fine art, collectibles include rare wine, vintage cars, stamps, baseball cards, coins, and basically any tangible item that can be sold for a higher price than it was bought. Investing in collectibles means buying and maintaining physical objects in hopes that the value of the asset will appreciate over time.
Collectibles can be a fun investment asset, and often collectibles investors are individuals with a passion for the items they are collecting. But there are risks involved. Firstly, the cost of acquisition can be large, such as purchasing a vintage car. Also, there is no current cash flow provided by these assets. More than a lock-up period, these assets are intended to be held for a significant period of time in order for the asset to appreciate in value.
The maintenance of collectibles can also be a risk for investors. If not properly stored and cared for, rare and antique items can lose value. One option for investors is to pay for the storage, but this can come with hefty fees. For investors not looking to take on the upfront cost or storage cost of collectibles, there are investment funds available that allow the purchase and sale of shares in a diversified portfolio of collectible assets.
Structured products are pre-packaged investments that provide a return based on the performance of an underlying asset. These notes generally include assets linked to interest plus one or more derivatives. There are a vast number of ways to structure these products, which is why these vehicles can be attractive to accredited and retail investors alike.
Generally, structured products are linked to an index or basket of securities, and are designed to facilitate highly customized risk-return objectives. This is done by using a traditional security such as a dividend-paying blue-chip stock and replacing the usual payment features with a non-traditional payout derived from the performance of one or more underlying assets.
Because these products are highly customizable, they can be crafted for an investor’s specific risk appetite. They can be principal-guaranteed, they can offer coupons at differing periods, and can provide downside protection, or upside multipliers.
Private equity refers to any capital investment made into a private company. This includes venture capital which focuses on start-ups and early-stage companies, growth capital which focuses on the expansion or restructuring of more mature companies, and buyouts which refer to when a company or one of its divisions is purchased outright.
Historically, there had been minimal regulatory oversight for private equity funds because most investors were high-net-worth individuals. That landscape changed in 2010 with the introduction of Dodd-Frank. Prior to Dodd-Frank, general partners in private equity funds were exempt from the Investment Advisers Act of 1940 because they restricted the number of investors.
Dodd-Frank now requires all private equity firms with more than $150 million in assets to register with the SEC in the category of “Investment Advisers.” Private equity funds now are also required to report information regarding their size, services offered, investors, employees, and potential conflicts of interest.
Private debt refers to investments that are not financed by banks but instead get an investment from a private individual. For private debt, unlike private equity, the “private” refers to the investor as opposed to the borrower of the debt.
Private debt is leveraged when companies need additional capital to grow. Both public and private companies can issue private debt. These instruments generally make money through interest payments and the repayment of the initial loan, similar to other fixed income instruments.
Hedge funds are investment funds that trade relatively liquid assets. Funds employ various strategies with the goal of outperforming the broader market. Hedge fund managers often specialize in a variety of skills to execute these strategies. Strategies include long-short equity, market neutral, volatility arbitrage, and quantitative strategies.
Hedge funds are available only to institutional investors such as pension funds, endowments, or high-net-worth individuals.
Characteristics of Alternative Investments
Alternative investments are often used as a diversification tool to reduce overall portfolio risk exposure. Below are some of the most common characteristics that differentiate alternatives from traditional investments.
Low Correlation with Traditional Markets
On wall street, correlation refers to the relationship between the returns of two investment assets. Correlation values can fall between -1 (perfectly inversely correlated) and +1 (perfect linear correlation).
The correlation value is largely dependent on sources of returns for the investment vehicles. The factors that affect equity market prices differ from what affects fixed income prices, and so on. Each asset class is exposed to unique risks, so correlations vary.
According to a Citi report, alternatives offer a lower correlation to traditional markets because they source returns differently. This can make alternatives an appealing portfolio diversifier.
An illiquid asset refers to one that is difficult to sell or exchange for cash when compared to fixed income or stock shares which can be easily sold on the open market. Depending on the type of alternative asset, there may be a limitation on withdrawal of the investment called a “lock-up period.” For hedge funds, lock-up periods can be anywhere from 30 days to a year, but in private equity or real estate, they can be as long as 10 years or more.
Collectibles such as fine art or rare wine are always less liquid than traditional assets but not because of a lock-up period. Hard assets like a large painting are illiquid because it simply might be difficult to find a buyer. Rare collectibles often have to be sold through an auction house or another third party, meaning the asset cannot be sold in only a few seconds the way a stock or bond can.
Not all alternative assets are highly illiquid. Liquid alternatives can be mutual funds or ETFs that aim to provide investors with diversification and downside protection through exposure to alternative investment strategies. Same as other mutual funds or ETFs, these assets can be bought and sold quickly on public markets, making them a more accessible option to gain exposure to alternatives.
Additionally, alternative investment vehicles exist that offer a secondary open market to buy and sell shares on. Institutions that offer fractional shares in collectibles or other alternatives are more likely to host secondary markets to offer increased liquidity to investors.
Traditional investment fees can range anywhere from 0.05% to slightly over 1%. Alternative investments generally have higher fees. These fees are usually broken up into management and performance fees that can be as high as 20%. This fee structure is generally justified by strong performance.
Certain alternative investment vehicles such as REITs or fractionalized shares often have lower fees, but as a whole, alternatives face higher fee structures than traditional investments.
Differences in Regulation
Many alternative investments face fewer regulations from the US Securities and Exchange Commission (SEC). Generally, the differences in regulation are because the investor profile for many alternative investors is more sophisticated than traditional assets. However, regulation is not necessarily lower across the board, SEC regulation varies across different alternative assets.
Alternatives fall under the purview of the Dodd-Frank Wall Street Reform and Consumer Protection Act, and their practices are subject to examination by the SEC. However, unlike traditional assets, alternatives often do not have to register with the SEC. Some of these investment vehicles are only available to institutions or accredited investors because they are unregistered.
Because of these differences in regulation, private markets can be much more opaque than public markets. Private companies are not required to report earnings or financial information to shareholders or to the public, which can make financial analysis difficult. This is more true for assets such as hedge funds or private equity compared to structured products or commodities.
Due to the more complex nature of alternative investments, they often have more risks associated with them. As noted above, there is illiquidity risk and time horizon risk that investors need to be prepared for before investing in alternatives. This is also why creating an asset allocation model can be an important step in determining how much illiquidity an investor is able and willing to take on.
Historically, most alternative investments have been available only to wealthier investors – requiring a level of SEC determined sophistication before investing. With the introduction of alternative investment funds and fractional ownership of commodities and collectibles, that barrier is not as high as it used to be.
However, there still are alternative investments that require investors to meet a certain threshold of sophistication or net worth before they can purchase.
Why Invest in Alternative Investments?
Alternative investments have gained popularity over the past decades due to greater access for retail investors as well as traditional portfolio strategies becoming less reliable. The 60/40 model, for example, has been unable to provide the same returns it was getting in previous generations.
Alternatives can offer greater portfolio diversification without sacrificing the potential for returns. Low correlation to traditional markets allows alternatives to act as a hedge against volatility and inflation.
This post is provided for informational and educational purposes only. It is not intended to be investment advice and should not form the basis of an investment decision.