Arguably, most investors don’t need to cast their nets beyond the tried-and-tested categories of conventional investments: stocks, bonds, cash and related instruments. However, did you know that the ultra-rich store up to half of their wealth in so-called alternative investments?
That’s according to a survey conducted in 2020 by investing firm KKR. It seems these “alternatives” are worth knowing about. While traditionally the hunting ground of institutions and the wealthy, many exciting alternative investments are becoming more accessible to retail investors
Contents: Alternative investments
- What are alternative investments?
- What are common alternative investments?
- Are alternative investments worth it?
- How do I invest in alternative investments?
- Alternative investment funds
What are alternative investments?
The clue is in the name: alternative investments are any appreciating or income-generating asset apart from the more usual items in an investment portfolio, which are normally restricted to stocks, bonds and cash. Alternative investments are also referred to as alternative assets.
The word “alternative” might make it sound like these investments are something kooky, but it’s likely that you already own some of them, such as property or classic cars. There is a wide range of investment types that fall under the alternative umbrella, and they will all suit different types of investors with different investing horizons and tolerances for risk.
Commodities like spot gold (XAU/USD), CFDs and cryptocurrencies are all regarded as alternative assets. Next, we will cover the most popular alternative investment types.
What are some common alternative investments?
Some fairly niche alternative investments, like NFTs (Non-Fungible Tokens) and Pokemon cards, do exist. All the same, there are six investment classes that serious investors typically think of when they want to add some alternative investments to their portfolio.
1 Real estate (property)
Real estate, despite being dubbed an alternative, is the world’s largest asset class. Between rising populations, increasing standards of living, and inflation, the price of property tends to rise quite reliably over time. Retail investors are familiar with housing from their own lives, making it a popular choice among those who like to have real assets alongside intangibles like equities and bonds. Investors typically aim to receive a rental income from either residential or commercial property. Then, assuming that the price of the property increases as years go by, real estate offers both income and capital appreciation.
Individual investors can buy a house as an investment or invest in property funds that own and operate a wide range of properties, perhaps including commercial properties that would otherwise be too costly for an ordinary person to purchase. The biggest problem with buying and selling real estate is the high transaction fees involved.
2 Commodities
Commodities are another example of real assets. This category typically includes natural resources like gold, oil, and agricultural products. Commodity prices move largely according to supply and demand, which can often be hard to predict without detailed industry knowledge. For example, demand for coffee has grown steadily over the last two decades, but there will still be occasional supply shocks when growing countries like Brazil experience a bad harvest.
In practice, retail investors can trade commodities via futures, CFDs and specialised ETFs.
3 Hedge funds
Hedge funds get their name from the original concept of hedging pooled investments in stock and bond markets by taking out short positions to offset the risk of a market dip. These days, hedge funds employ hundreds of different trading strategies. They will typically invest in liquid assets but assume greater risk, including by using leverage or derivatives.
4 Private equity
Just as the name implies, private equity means investing in the ownership of private companies that are not listed on any stock exchange. Private equity is typically divided up into two categories:
- Buyouts – purchasing a whole company with the aim of re-selling it for more later.
- Growth or venture capital – taking a partial ownership stake in either startups or mature companies in hopes of seeing them grow.
5 Private debt
Just like private equity means trading shares off the stock market, private debt means buying and selling debt outside the conventional bond market. Private debt offers a way for companies to borrow money not from a bank, nor using conventional means. Both private and public companies can issue private debt in order to raise capital.
6 Collectibles
These investments are diverse in nature but can be grouped together as anything that one might hold partly for sentimental value. Collectables include art and antiques, stamps & coins, classic cars, and many other items expected to retain or increase their value. These are quite possibly the most fun investments: if you can own a bit of history, and even perhaps use it while its worth grows, it’s a win-win! The problem with collectables is that beauty is often in the eye of the beholder. Tastes change, affecting how much even knowledgeable collectors can sell their investments for.
Are alternative investments worth it?
Alternative investments, on the whole, have some particular pros and cons that anyone looking into buying them needs to be aware of.
Advantages of alternative investments
Diversification
The main reason to want to invest in alternatives is to diversify away from stock and bond markets. Alternatives tend to have very low correlations to conventional assets, so if there is a bear market, these investments can offer a hedge.
Inflation hedge
Investments in hard assets such as gold, oil, and property have traditionally shielded the wealthy against inflation. Inflation means the purchasing power of money is gradually reduced, but hard assets hold their value by getting re-priced as worth more of the devalued currency.
Disadvantages of alternative investments
Illiquid and non-fungible
If an item is unique, it cannot be easily interchanged with the same or similar items, and that implies there are fewer transactions in such assets. Your 100 shares of Apple stock are worth just as much as the next person’s, and Apple has issued millions of shares. Selling stocks or bulk commodities is a different proposition from unloading 100 bottles of ‘88 burgundy from a famous vineyard.
Valuations
Knowing how much your investment is really worth is, of course, a challenge every investor faces. However, this can be even harder when it comes to alternative investments. Often, specialised niche understanding is required to know if something is a good investment or not.
High minimum investments
Some alternative investments, like hedge funds, generally have specific barriers to entry, perhaps a $1 million minimum investment or prohibitive fee structures like the “2&20 rule” (charging a 2% annual fee and 20% of profits). Some alternative investments are effectively restricted to institutional investors or accredited high-net-worth individuals. (In the US, this means a net worth exceeding $1 million, not counting their residence, or a personal income of at least $200,000 per annum.)
Unregulated
Because of loose regulation, alternative assets are probably one of the investment categories most susceptible to fraud. The true price and ownership of the assets being invested in are more opaque, so extra due diligence is required.
How do I invest in alternative investments?
For those of us whose invitations to Davos got lost in the mail… There is a novel way to invest in alternatives without directly getting involved yourself. If you like, you can follow a passive investing approach to alternative investments by using alternative investment funds.
Alternative funds
Alternative funds are simply mutual funds or ETFs that invest in alternative assets. Each fund will typically focus on a specific area, like commercial real estate, unlisted securities or fine wines. As a retail investor, you need to just buy the ETF that matches your area of interest.
A quick search for ‘alternative’ inside any online trading platform shows multiple funds and ETFs accessible to retail investors.
