What is an Alternative Investment?

UTC by Adedamola Bada · 7 min read
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What is an Alternative Investment?

The topic of alternative investments is quite broad and covers a lot of asset types but for the sake of simplicity, this guide will narrow it down and provide you with the key basics you should know.

Basically, an alternative investment includes every type of investment you can think of except three traditional asset classes: cash, stocks, and bonds.

Alternative investment actually promises great returns but at the same time, it is unpredictable due to its lack of regulation in most parts. Also, its liquidity potential leaves more to be desired. Taking all this into consideration, it can be said that alternative investment is quite risky.

Assets that make up alternative investments comprise art and antiques, venture capital or private equity, derivatives contracts, commodities, hedge funds, and real estate.

Understanding Alternative Investment

A lot of alternative investments are not for little spenders as only those with deep pockets can afford to invest in them. Things like expensive minimum investment fees make the entry barrier of this asset type a very high one for the average investor. Also, investors do not have the luxury of easily converting alternative assets to cash as quickly as they would with their traditional counterparts.

All in all, due to alt investment’s lack of regulation, complexity and risk level, usually only accredited, wealthy individuals or institutional investors are those who choose this type of investment.

However, there is an upside to alternative investments, even with its high initial minimums. Conducting business with alternatives is cheaper when compared to traditional assets, because of its low gross revenues.

Examples of Alternative Investments

The need to grow one’s portfolio is found in most investors and today, various investment strategies can serve such purpose, one of which is alternative investments.

Hedge Funds

From its various trading strategies to conducting transactions in non-traditional markets, the promises held by hedge funds are not easily obtained anywhere else. Some of the things that set hedge funds apart are:

  • Investors are shielded from market volatility.
  • They place lesser restrictions on investments.
  • Investors have access to a broad opportunity set.
  • They make use of the best trading strategies and experts to add value to investments.
  • They can be classified into five divisions: Multi-Strategy, Managed Futures, Distressed, Long/Short Positions and Global Macro.

Private Equity

This market differs from its public equity counterpart, just the same way as its returns and diversification differ. Investors can take advantage of private companies to enjoy enhanced profits. Here are some of its benefits:

  • It adopts a long-term strategy on investments compared to the quarterly earnings synonymous with the public market.
  • Investments perform well, be it on an absolute or a risk-adjusted basis.
  • Private equity investments are lucrative regardless of a company’s current stage in its life cycles: venture capital, growth periods, buyout and reorganization.

Commodities

Businesses relating to natural resources have always been beneficial ever since the days of early civilization. Things like precious metals, agricultural products, industrial metals, and energy will always be good investments.

Types of Commodity Investments:

Index Funds, or an index containing a list of commodity assets.

Commodity Funds, which have a more personal relationship with commodity assets by directly investing in the underlying asset.

Futures-based Commodity Funds, which use futures contracts to shed light on commodities. Futures contracts are the investments in this case and not the underlying commodity asset. It is also considered a high risk because the futures contracts market is very unstable.

Real estate serves as a great option for the diversification of the portfolio. These investment has evolved from being a playground for the wealthy to become something anyone can invest in. Today, the low entry barrier provided by publicly traded exchange-traded funds (ETFs) and trusts for real estate investing has made it more attractive to investors.

Managed futures refer to an investment where a portfolio of futures contracts is actively managed by professionals. Funds and institutional investors often use managed futures to ensure both portfolio and market diversification.

Art and Antiques type is known for its unchanging value even in the face of inflation. These comprise gems, antiques, collectibles, and art. They make a good investment, especially for those who have other assets that are easily affected by market conditions.

Derivatives contract, which is an agreement between two parties, which obtains its price or value from an underlying asset.

Cryptocurrency is yet another type of alternative investment. Though it is referred to as a high-risk investment, its return is quite high. Investors who are looking for a long-term investment should consider cryptocurrency because it has a high chance of surviving even the worst financial crisis.

Alternative Investment Pros

There are moments when owners of alternative investments will feel good about their choice and that usually comes when it’s time to pay taxes. An alternative investment has a more gentle tax load compared to conventional investments.

Alternative investments are subject to certain factors that have the power to either lower or raise its value. In the case of reduced value, investors may purchase it at a cheaper rate to hold over some period, during which the price is expected to bump up.

Alternative Investment Cons

There is a laid down rule with regards to alternative investments known as the 2 and 20 fee structure. It simply means that a management fee of 2% will be required from you, as well as a 20% commission rate in the event the fund goes beyond a specific return threshold. Now, here is the risk: if for any reason the fund does not do well, or performs badly, the capital invested will suffer a great cut as a result of the high fees.

The complexity of some alternative investments can make the planning and execution of business strategies quite difficult.

Some alternative investments do not give chance for liquidity. Once the money of an investor goes into it, getting it out at will becomes almost impossible. Also, this asset class has little transparency and when measured against traditional investments on the same scale, it falls short.

Common Myths

It is not uncommon to encounter strange beliefs with regard to alternative investments. People who don’t understand the asset class tend to make up theories about it, of which the majority are baseless. The misunderstanding has led a lot of people to believe it is strictly designed only for the wealthy, while on the contrary, it is an investment anyone can be a part of if they so desire.

Myth: Stocks and bonds are less prone to volatility compared to alternative investments.

Truth: When considered individually, some alternative investments are very volatile more than conventional stocks and bonds, but as a group, alternatives are not worse than other investments. In reality, the issue of volatility is more pronounced in the stock market than in lots of alternative investments.

Myth: Investors can diversify their portfolio by simply choosing one alternative investment and putting money in it.

Truth: In the same way that investing in one mutual or stock fund does not mean that an investor has achieved meaningful diversification, one should not expect a lot of impact from only one alternative investment. Putting one’s money in a single alternative investment may give the investor access to certain diversification privileges but at the same time, the risk level is multiplied.

Myth: Invested money in all alternatives cannot be accessed.

Truth: How liquid an alternative investment has to do with the type of investment in question. Some make provisions for cash on a daily basis, like some alternative mutual funds, while limited partnerships can place limits on access to cash from as short as 30 days to over 10 years.

Summary

Alternative investments make a good choice for investors who want to try their hands on other types of assets. Their influence has the potential of reducing volatility, widen diversification and increase yield.

However, before choosing any alternative investment, the investor should thoroughly select based on what he hopes to achieve. Investors who go into alternative investments usually have a motivating factor driving their choice. Some go into the industry in order to step away from the familiarity of traditional markets to test new grounds.

Some investors who wish to make a long-term investment usually go for alternatives because it has the potential for a higher return. Furthermore, with alternative investments, investors can soften the effect of high-interest rates and inflation on their portfolio through hedging.

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