An alternative investment is a financial asset that isn't perched on any of the traditional investment branches.
Alternative investments often show low correlation with those traditional asset classes. Behaving as a counterweight to the stock and bond market makes alternative investments an ideal portfolio diversifier. Investing in the right assets, – gold, oil, property, - can act as a hedge against inflation. If the market tanks, these alternative strategies can be a saving grace in an investor's portfolio.
While these attractive qualities work to mitigate risk in an investor's portfolio, said investor needs to be comfortable taking a small risk to generate a large reward. Alternative investments typically have a high price tag. Commonly unregulated and often illiquid, those who invest in alternative investments must do so with care and caution. Nonetheless, if that proper precaution is taken, alternative investments can swiftly dominate an intelligent investor's portfolio and bank account.
The eight main alternative investments are:
- Private Equity
- Private Debt
- Real Estate
- Hedge Funds
- Structured Products
- Cryptocurrencies or Digital Assets
Let’s dive into what these are: the costs, benefits, and liquidity of each, and why they are worth incorporating into your portfolio.
Private equity refers to any capital investment made to a private company that is not listed on the public stock market. The purpose of private equity is investing funds into a corporation with growth potential that will hopefully generate impressive returns. While there are several subsets of private equity, these are the three main types:
- Venture capital
Money that helps a startup or early-stage business
- Growth capital
Money that helps mature companies grow or redesign
Money that purchases a company outright (or one of its divisions)
Pros of Private Equity
- As is the case with many alternative investments, private equity does not operate through traditional parameters. Unaffected by the public market, a company that receives capital from private investments doesn't need to operate through the restrictive confines of a bank.
- Companies that receive venture capital are granted more freedom to test-drive various avenues to success. Since money is invested at a business' infancy, the company at hand can afford more wiggle room to gain their footing and use trial and error to discover the best strategy, paving the way for higher future returns.
- Oftentimes, investing heavy capital in a company can earn an investor shares, or a percentage of control over the company. This control gives investors more confidence that their donation will come to fruition.
Cons of Private Equity
- This investment demands funds upfront. As with all investments, there is always the risk they might not pay off.
- This is why many private equity investors devote time to mentor businesses. The return on their investment is solely contingent upon the success of the company. This means private equity investors may contribute time and energy in addition to capital.
- This can be a lengthy and challenging process. Thousands of businesses sink each year. Investors must choose wisely which companies to invest in and have the patience to see the investment through.
- While control of a company can be seen as a pro, it can also be seen as a con. Unless donors invest in a buyout, their investment will only earn them a small portion of control over the company. Some investors become frustrated after investing so much into a company and still not overseeing executive decisions.
- Dilution can be uncomfortable if shareholders are sensitive. When new investors are introduced, shareholders sometimes struggle to relinquish control of the decision-making procedure within their business.
Financial liquidity is the measure of the speed and difficulty inherent in turning an investment into cash. Private equity is often argued to be illiquid as investments take a long time to pay off. Returns are results of a handful of smart business strategies, a spoonful of public opinion, and a dash of luck. However, the concoction brewed from these ingredients can pour a lucrative cocktail for investors.
Private debt operates similarly to private equity as is not traded on the open market nor financed by big banks. Technically, both public and private companies can borrow private debt. However, that private debt is leveraged by private debt funds when a business needs an extra boost of capital to get where they want to be. These private debt funds make money either via interest payments and/or repayment of loans.
Not born out of the Global Financial Crisis but perhaps gestated by it, private debt was previously a sub-category of private equity investing. The crisis opened a space for debt acquisition as many companies were forced underwater when the market imploded. Since then, private debt has become a staple alternative investment.
Pros of Private Debt
- Debt acquirers are the priority in a company's liquidation. When a previously-in-debt business finally makes a profit, debt holders are paid before anyone else, including stockholders and founders.
- In the spirit of generosity, many businesses will offer stock in the company to the generous investors who acquire looming debt. This minimal control over the company can be of great advantage to investors.
Cons of Private Debt
- Debt is a liability. Liability is not a promising financial characteristic. Many investors may be hesitant to invest in a company with such pressing liabilities.
- Just like debt to the bank, private debt is treated like a loan. Monthly payments are scheduled to the debt holder. For companies that severely need funds to re-grow their business, debt acquisitions can be a cash drain. However, this could be seen as a pro for the debt holder.
If the liquidity of private equity investments was low to the ground, that of private debt investments is deep in the soil. It takes a long time for a company to build enough capital to pay off its debts. It requires years, sometimes decades, of determination, patience, and faith to generate impressive cash returns.
Hedge funds, to put it simply, are investment funds that provide capital for the sole purpose of earning more capital later. Hedge funds invest large sums of capital into agencies they believe will later have a large return. To be successful, investors must employ important skills such as long-short equity, market neutral, volatility arbitrage, merger arbitrage, and quantitative strategies.
The title of hedge fund stems from the various trading techniques employed to generate impressive returns. Investments become hedges when they are employed as a counterbalance to the public market's performance. Investors can go long if they foresee a market rise or they can short stocks if they forecast a market drop. Though no one can anticipate the public market, those who pay close enough attention can earn a pretty penny from their predictions. Hedge investors are a tight-knit clique. Hedge funds are often exclusive, open only to institutional investors such as endowments, pension funds, mutual funds, and high-net-worth individuals.
Pros of Hedge Funds
- Hedge funds are not traded publicly, which offers more flexibility. They eliminate the restrictions of a governance that regulates their performance.
- Hedging against the market is one of the most popular forms of portfolio diversification. If some of your money bets for the public economy while the rest of it bets against the economy, then whatever happens, you can't lose.
- If you have enough funds and enough internet access, the world is your oyster. You can observe the market as much as you like and invest in whatever you see fit. Not all alternative investments allow this much freedom.
- Leverage is ever present in hedge funds. In a leverage strategy, the investors will borrow and trade money on top of the capital that they will gain. The benefit of the strategy is that it can enhance returns. However, anticipation for a huge gain is a measure against the chances of huge loss. Thus, if the hedge fund managers are to use this strategy, then complex tools to manage the risk should be in place.
- Hedge funds offer expert advice and transparency. The hedge funds managers, aside from being advanced in matters to do with investment, they are also well versed in financial management matters. Therefore, when you go to the market, as an investor, you are sure to get the best information. They offer advice on which hedge funds to use, future predictions in the performance of individual funds, as well as offer handsome payments to their workers.
Cons of Hedge Funds
- Hedge funds practice aggressive investment strategies. Not everyone has the stomach for it, nor does everyone have the wallet for it.
- Short selling, leverage buying, and derivatives are all examples of aggressive investment strategies. When climbing to a high peak, there is always the risk of falling. The more aggressive the return, the more aggressive the risk. But, the higher the risk, the higher the return.
- Many hedge funds use standard deviations to anticipate risk. While this is a smart way to stay organized and keep eyes on the data, it measures volatility of possible gains, thus not always painting an accurate picture of the risks.
The liquidity of hedge funds used to be simple (as simple as liquidity in a capitalist economy can be). But when investors scrambled to redeem their investments during the Global Financial Crisis of 2008, hedge fund liquidity changed forever. Investors, concerned by the restrictions preventing them from accessing their capital, now demand more transparency and accountability to mitigate hedge fund liquidity, or rather the risk of a lack of liquidity.
Real Estate Investment
Real estate is the most common type of real assets. It's also the world's biggest asset class. The goal of real estate is capital appreciation – investors want to increase the long-term value of the purchased physical asset, a house or apartment complex. In the meantime, property owners receive expected cash flows associated with income generated by tenants of the property.
The liquidity of real estate investments depends on what type of strategy is used. For example, buy-and-hold is perhaps the most common real estate investment strategy. This is generally accepted as an illiquid strategy as investors must wait for the property value to appreciate before receiving a healthy return on investment.
Alternatively, the fix-and-flip strategy is a drop more liquid. Via this tactic, investors purchase a property, fix it up, and then sell it for (hopefully) a profit. While this can produce a quicker return, it still presents a liquidity crunch. Investors must make enough of a profit to return on not only the money they invested to purchase the property but also the money they invested in fixing it. The liquidity levels inherent in each real estate strategy vary, but all of them require extended periods of time.
Pros of Real Estate
- Well-chosen properties more often appreciate than depreciate. Of course, there are the occasional market corrections, but real estate will always have an intrinsic value because of the physical structure and the raw land it sits atop.
- Real estate investments incur specialized tax benefits. These benefits typically include some sort of depreciation and lower tax rates on long-term profits. Rental properties will sometimes offer an overage of tax deductions that can be used against other forms of income. Many expenses that can be tied to running a real estate business are tax-deductible. It's also helpful that rental income is not subject to a self-employment tax.
- ROI can either be massive and instant or small and steady. Either way, money always comes in.
- Real estate will never go away. People will always need homes. It's never too late to get in the game.
Cons of Real Estate
- A common finance mantra is, "you need money to make money." Real estate is a prime example. Not just anyone can invest in real estate. It takes exorbitant sums of money not only to purchase a property, but also to turn it into a home that will rein in more money than you spent to obtain it.
- Real estate is a long-term strategy. Investors must be comfortable purchasing a tangible asset that they cannot immediately liquidate in the event of a financial emergency.
- Real estate investments involve other people; it's not a solo operation. Real estate investors must be comfortable dealing with tenants and contractors and other people filled with opinions. This investment branch is not for the faint hearted.
- Real estate investments' popularity can be seen as a downside. So many people are doing it nowadays, it almost seems easy. However, it is very easy to lose money if you don't know what you're doing.
Commodities are one of the earliest forms of investments. Throughout history, people have invested in valuable goods that they believe will appreciate with the aims of attaining an attractive ROI. These goods are real and tangible, the most popular commodities being agricultural products, oil, gas, and metals, both precious and industrial.
These real assets and (mostly) natural resources are frequently used as hedges against inflation. None of the commodities mentioned above positively correlated with the public market. Instead, their value peaks and valleys based on supply and demand; higher demand leads to higher prices which leads to higher profit.
Though value rises and falls over time, most of these commodities stay inherently valuable. Take gold for example. Since its discovery, gold has dwelled at the top of the financial pyramid. It is valuable not only because of the beauty it harbors around a celebrity's neck, but also because of its role in medical and aerospace technology as well as electronics and dentistry. Gold always has been valuable, and it likely always will be. Intrinsic value, lack of credit risk, and upheaval insurance are all decent reasons to invest in gold. However, the golden goose is that precious metals are inversely correlated with the public market, making them an intelligent investment. Not only will it likely appreciate over time, but it also can offer inflationary protection during economically uncertain times. Even just a small investment in gold can minimize both volatility and risk.
Pros of Commodities
- Diversification. If half of your money is in stocks while the other half is split among various commodities, you are likely to have a cautious portfolio. If the market tanks, you have resources that have been slowly generating wealth that will counterbalance what you lost during the downturn.
- Mentioned above, commodities are inversely correlated with the public market. This makes them the optimal hedge against inflation.
Cons of Commodities
- Because people’s interests are so fickle, so is the supply and demand of commodities. The ever-changing nature of human decision making makes commodities extremely volatile.
- While diversification is key to any successful portfolio, investors must select commodities wisely. The value of certain popular commodities like oil and gas fell drastically along with many other businesses during the 2008 financial crash. Commodities can be an impressive protector against inflation and financial crises, but they must be well selected and well timed.
As far as liquidity goes, commodities are often seen as relatively liquid investments. However, because the commodity industry is so broad, each resource holds differing liquidity. For instance, agricultural and energy commodities are more liquid than metals. Among metals, gold is more liquid than platinum and copper is more liquid than aluminum. Oil, gas, gold, wheat, corn, and copper are leading the liquidity charts in the commodity arena.
Someone invests in a collectible because they are confident the value is going to appreciate over time. Perhaps the most interesting investment source, but also perhaps the riskiest; collectibles are expensive. Investors need to be sure that the vintage baseball card they purchased is going to pay off later. Time is often a collectible's greatest asset. Time can appreciate and depreciate a collectible depending on what it is and the public's opinion about it. Another challenge for collectible investors is selling it at the right time. Investors must pay a great deal of attention to trends to get the most bang for their buck.
Investors need to be very careful about not just how to purchase a collectible, but how to maintain the purchase and sell opportunely. Collectibles are difficult to store properly. If any damage incurs on a collectible, almost all value is lost. However, this practice is changing with the innovation of NFTs. Non-fungible tokens are crypto-collectibles; they tokenize a digital asset. Instead of paying half a million dollars for a rare wine, you can now pay half a million dollars for a gif of a cat. Virtual, verifiable, personalized, and unable to destroy, delete, or replicate, NFTs are the future of the collectible business. With the COVID-19 pandemic pushing most of life online, NFTs became a popular investment strategy capitalizing on collectibles such as art, sports, and many more genres.
Pros of Collectibles
- Collectibles embrace a vast network of value. Humans are socially and spiritually invested in so many interesting niches that carry high worth: art, agriculture, sports, technology, etc. Any of these can be tapped into with collectible investments.
- With collectibles, an investor can make money off things that interest them. Stocks may have high liquidity but they aren't always interesting. A vintage automobile collection on the other hand is arguably much more exciting.
- Many collectibles are physical, tangible items, which means they are portable. Throughout history, many refugees have fled their home countries with only the clothes on their back and the valuable collectibles that they planned to exchange for cash when they get to their desired destination.
- Most collectibles are universally valuable, meaning you can trade them for roughly the same price anywhere in the world.
Cons of Collectibles
- Collectibles are a long-term investment. Again, an investor only purchases a collectible if they are confident the value is going to increase over time. Collectibles do not have quick liquidity turnover; items require multiple years, sometimes decades to appreciate in price.
- Just because you invest in that vintage automobile collection doesn't mean you get to drive all those fancy cars. Remember that collectibles must stay in mint condition if they are to retain their value. That means investors can't always play with the toys they buy.
- Sometimes there are tax rules that prevent investors from playing with their purchases. Some see this as a con, a tease. However some see this as a pro, a protection of their wealth.
- While it is fun to invest in your personal hobbies, it is easy to get sucked into the fantasy that everyone else will eventually become passionate about what you are passionate about. Vintage cars are in style now but there may come a time in which they are not. Stick to your guns about what you think is important, but bear public opinion in mind. Supply and demand are what controls the value of collectibles, which is what makes it such a volatile investment strategy.
- The collectible arena is teaming with con artists. Thousands of people out there are devising schemes to persuade you to invest in something that is destined to depreciate. Stay sharp. Do your research. Trust your gut.
Liquidity is tricky with collectibles. These goods do not produce income; the only money earned from them is the sum you receive when you sell them. Some collectibles like art or jewelry are easy to sell at a pawn shop or an auction. Others are more challenging.
Determining when to sell can be a frustrating decision. Trends evolve, and in turn so does supply and demand. The market might not be ready to buy when you're ready to sell. Time is perhaps the most crucial factor regarding the liquidity of collectible investments.
Structured products are investment vehicles built by combining various financial instruments. These instruments are compiled into an indivisible, pre-packaged investment strategy that operates in conjunction with an underlying asset, often an interest rate-linked product and/or financial derivative.
Assets could be stock indexes, shares, exchange, or interest rates, and more. Each structured product is unique, with predefined terms that carry their own risks and rewards. For example, the capital at risk is predefined as is the amount of time an investor wishes to participate. Structured products can be purchased by institutions, retail clients, and high net worth individuals, and are customized to each buyer's needs.
Pros of Structured Products
- Structured products usually offer some form of capital protection. The payoff profile of structured product packages is guaranteed.
- Investors can gain access to new markets or asset classes that aren't traditionally available through domestic securities.
- Structured products are essentially a contract. Once agreed upon, the relationship between both parties becomes quite simple. Not much needs to be done on the investor's side after the package is agreed upon.
- Tax implications, depending on the package.
Cons of Structured Products
- Counterparty risk is the possibility that the counterparty to the product you purchase may not be able to live up to its contractual obligations.
- As many structured products are linked to the public market, market risk is always a factor.
- Due to the services provided by intermediaries, there are often fees included in structured product packages.
- Tax implications, depending on the package.
As mentioned above, structured product contracts include an end date. When that date comes, whoever is participatory in that contract will pay the investor the agreed amount. If the investor has an emergency liquidity need before that date however, the firm that signs the contract is (usually) the only entity that can buy back the contract. Sometimes this is not possible; sometimes it is possible, but only in conjunction with a hefty fee. It's all dependent upon the predetermined contract.
Cryptocurrencies or Digital Assets
One of the newest and increasingly popular investments, cryptocurrencies represent digital units of value that are currently mostly unregulated by most governments and banking compliance regimes. This allows them to operate in tandem with traditional markets. Though not completely proven as a hedge, cryptocurrencies fluctuate on their own volition and can act as a countermeasure to protect an investment portfolio if the market tanks. The nascence of this digital platform may intimidate some, but the success of cryptocurrencies such as Bitcoin and Ethereum have made some believe in their endurance.
The volatility of cryptocurrencies has also contributed to the intimidation felt by some investors. When investing, it's important not to let price changes in the market lead you to believe you made a bad decision. Keep in mind these types of investments are long term. Remember that Bitcoin crashed in June 2021 and is now at its five-month high in October of 2021. Don't be afraid to play the long game.
Pros of Crypto & Digital Assets
- Cryptocurrencies present the potential for high returns. In the five years leading to December of 2020, the S&P 500 index of US equities grew at a rate of 14.5%. Over the same time period, Bitcoin grew at 131.5%.
- As with all alternative investments, cryptocurrencies are a portfolio diversifier, which is believed to behave as a hedge against inflation.
- Cryptocurrency's blockchain technology is decentralized. This lack of middleman allows investors to bypass fees traditionally charged by big banks.
- Transparency is a huge contributor to cryptocurrencies' success. Every transaction is monitored and recorded in a public ledger, known as the blockchain. This ledger is transparent and cannot be changed once it's confirmed.
- Though hackers are listed as a con, blockchain technology ensures all transactions are secure and confidential, making identity theft and fraud difficult to pursue.
Cons of Crypto & Digital Assets
- The most obvious hesitancy many feel about cryptocurrency is its infancy. It is so new; not many people trust it yet. Though it has been successful so far, cryptocurrency hasn't been around long enough to prove its success is sustainable.
- As is the case with all digital platforms, there is the possibility of hacking. Though the cybersecurity shielding cryptocurrencies has seemed strong so far, again, cryptocurrency is new and anything is possible.
- Operating under the private sector, cryptocurrencies are unregulated, paving the way from scammers and hackers.
- Bitcoin and cryptocurrencies only exist in digital form; they are stored in digital wallets accessed with a private access key. As there is no central authority figure, if you lose your private access key, you may lose your cryptocurrencies forever. As of now, there are no mechanisms to help recover lost cryptocurrencies.
Though it may require additional cost and time to exchange cryptocurrencies into cash, the low liquidity of cryptocurrencies has not yet proven enough to prevent investors from adding this alternative investment to their portfolio. As is everything on the internet, beginning the process of liquidity in cryptocurrency is nearly immediate. Cryptocurrencies operate 24/7/365; traders can access their investments at any time. Also, the more people that invest in cryptocurrency, the easier it becomes to turn investments into cash. As crypto becomes increasingly accepted, the liquidity grows. So, if you want to make your crypto-investments more liquid, tell your friends about it.
There is no one-size-fits-all recipe for investing. Some investors are glued into the stock market. Some pay close attention to bonds. Others toy with alternative investments. While none of them are more correct than the other, a healthy dose of them all can balance a portfolio well. Alternative investments are a method of storing money in revolutionary ways that can protect investors from the blinding tunnel vision of sticking to one investment platform. We hope this breakdown was helpful in opening your eyes to the power a diversified portfolio can have.