What are alternative investments? It’s the term for non-conventional financial assets with implementation of alternative investing strategies. Traditional investing categories include stocks, bonds, and cash, so anything that falls out of these classes can be considered alternatives (for example, fashionable items, real estate, and venture capital).
How alternative investments work
Alternatives is an extremely dynamic category that covers a lot of investment classes. Today, their accessibility increases among all groups of investors, thanks to a rising financial awareness and a growing number of alternative investment platforms. A list of such platforms can be found here.
The range of assets is vast and diverse, though most of them have something in common.
- Alternative investments are not under regulation by the US Securities and Exchange Commission (SEC).
- They are mostly illiquid, i.e. investors might have trouble getting rid of them when they want to quickly convert them to cash.
- Because of lower correlation to market conditions, alternatives aren’t strongly dependent on changes in the economic environment.
Traditional vs alternative investments
To better understand alternatives, we need to learn in what ways conventional and non-conventional investments are different. Traditional strategies mostly utilize public stocks and bonds, while alternative investments exploit inefficiencies in markets and focus on non-traditional assets.
Below, you can see a short comparison table of both categories.
Advantages and disadvantages of alternative investing
Here are some positive sides of investing in an alternative option.
- Possibility of higher ROI. While non-traditional investments imply higher risks, they might also bring more beneficial returns.
- Lower correlation to markets. When compared to conventional assets, alternative investing does not correlate as much. So if the stock market experiences instability, alternatives might still show great results.
- Low volatility. With lesser exposure to public markets, alternative assets aren’t as impacted by their volatility.
- Diversification improval. Because non-traditional assets show lower market correlation, they will greatly boost portfolio diversity.
- Inflation risk hedges. Certain alternatives (gold, natural gas, real estate, etc.) can be efficient in hedging against inflation, as well as rising and falling prices.
However, investing in alternative assets entails some risks.
- Higher entry level. Historically, alternative assets were traded by wealthy and experienced investors, so the very structure of this market does not suit average investors. That’s why minimal requirements of investing in non-conventional assets are typically higher in comparison to a stock market.
- No regulation. Some non-conventional assets are not supported by the SEC, so they can neither be registered nor regulated by it.
- No transparency. Without SEC regulation, alternative investments also lack public databases. It means that investors can’t access information on certain assets, and most deals are non-transparent.
- No market prices. Determining the prices of non-conventional assets is also difficult because they are not presented in the market and investors can’t look up their fair market value. It makes valuations more subjective as they mostly depend on a seller’s considerations.
- Potential illiquidity. Since there’s no public trading of some alternatives, purchasing and selling them can be challenging. Also, certain funds might implement lockups during pre-determined investing periods to prevent redemptions.
- Entailing risks. As mentioned above, alternatives have higher ROI potential. However, it is explained by riskier strategies and higher chances of failure.
Who can buy alternative assets
Historically, purchase of most non-traditional investment was only accessible for financially-backed investors. Since alternatives are rarely traded in public and/or regulated by the SEC, investors usually need to have deeper knowledge or insight into a particular asset category.
Still, there are investment classes available for a wider audience. For example, a recent fever for NFTs can be explained by the fact that it gave common investors a possibility to convert their money into assets without having special acquaintances or skills.
Some of the roads will open to the investors who got accredited by the SEC. To pass the accreditation, a candidate is supposed to meet at least one of the criterias.
- Annual income: $200,000—$300,000 for the past two years (or longer).
- Net worth: maintained at the level of $1 million dollars (at least).
- An investor should be showing, as the SEC put it, “defined measures of professional knowledge, experience, or certifications”.
Types of alternative investments
Although there are quite some similarities and shared features between alternative assets, it’s a highly diverse category.
Here are the most notable options to invest in non-conventional assets.
That’s the term for private equity funds owning a diverse portfolio of assets (both traditionals and alternatives). They often employ aggressive strategies and other methods unavailable to traditional funds, such as derivatives, high leverage, arbitrage, etc. Since they are exempt from the Investment Company Act of 1940, there is no heavy listing and/or regulation of hedge funds.
Hedge funds aim at maximizing their short-term earnings. Redemptions are usually restricted, be it through a lockup period, a notice period, or redemption fees.
Private equity funds
Unlike hedge funds which invest in just about anything, private equity funds purchase shares directly from non-publicly traded companies. The most valuable are private organizations that show good profit and generate lots of cash.
Private equity funds frequently use leverage buyouts to purchase companies in distress. They are most interested in the long-term potential of their portfolio.
Typically, private equity funds deploy their assets in many small companies or startups in hope that at least one asset will grow at such a substantial rate that its returns offset the risk of loss in the others.
This type of alternative investment includes investing in buildings and land through a variety of instruments, for example, ownership, mortgages, public equity, etc. There is no fixed maturity, so property may be held for more than 100 years.
Real estate is owned via title deeds, often registered by the local government in the land registry. Real estate has many subcategories: residential, commercial, industrial, agricultural, and timberland.
Compared to other markets (such as equity), the market of real estate is inefficient. Because of information asymmetry, those who have special knowledge or insider data make better investments, hence getting better profits.
ROI comes in the form of net income from the property as well as capital gains from sales. With the exception of real estate securities (MBS), liquidity of such assets is low, and a single successful deal can take up to a few months.
In this case, investments are made into physical objects, such as oil, metals, and products of agriculture along with their underlying securities. Trading in commodities avoids storage and transportation costs associated with holding the underlying commodity.
Such an investment offers a chance to hedge against inflation, since government inflation statistics typically include the cost of oil, food, and other commodities.
Collectibles include a wide range of items. Here are some examples of the most popular objects to collect:
- art pieces
- fashion pieces
- musical instruments
- rare wines
- retro cars
- stamps, etc.
People who invest in collectibles would purchase and maintain physical items counting on the increase of their asset value over time. Typically, the older the collectible is, the higher the price. Other factors to consider are their quality, rarity, and condition.
Although collectibles seem to be more fun than traditional types of investments, acquiring them is less cost-friendly, and they are lacking dividends. Profit can only be made after selling a collectible. Since these objects are physical, they can also be easily destroyed or damaged, especially if the storage and/or care conditions are inadequate.
In this investing category, expertise and knowledge are key factors. To purchase items with higher return on investment, an investor needs to know the field of their collectibles through the length and breadth.
This type of asset attracts investors who are seeking stability over higher returns. There are “brown-field” investments, i.e. those either being sold or leased by the current owner (often the government), and “green-field” investments in new projects.
Infrastructural assets include factories, bridges, tunnels, toll roads, and communication equipment.
How to buy alternative investments
Extensive research is a must for any investor who considers making alternative investments. Purchase of alternatives brings higher levels of risk than conventional asset categories. Nevertheless, they are proportional to the potential of higher returns and positive effects of diversified portfolios.
Depending on the type of asset, the access to alternatives might be restricted. While some non-conventional investments are widely available for common investors (for example, stamp and/or coin collectibles, real estate, and gold), others can only be accessed in narrow circles.
Say, startup investments are mostly made by venture capitalists who have a tight-knit network of acquaintances in a specific industry. You simply won’t be able to invest in it as an outsider as your involvement would require high levels of expertise. Another type of investment — infrastructure — needs lots of financial support at the entry. Building a toll road or a shopping mall is expensive and takes lots of paperwork, so this option is not for anyone.
There are several ways to acquire alternative assets. The first one is auctions, such as Sotheby’s, Christie’s, Bonhams, Artcurial, Tajan. Another option is online sales. If you are a first-time investor, the exchanges would sometimes provide the buyer with a broker, and auction employees can also offer advice. Still, it is better to find an independent expert in a specific industry (i.e. fashion or diamonds) and discuss an investment strategy.
Wine bottles can sometimes be purchased on the exchange, including London International Vintners Exchange (Liv-ex), Berry Bros & Rudd, The Knight Frank Fine Wine Icons Index. The sale of art objects (mainly paintings) takes place through the Masterworks platform, where Warhol, Banksy, Rothko and others are represented. Clothes are sold through the Rebag and Vestiaire Collective resale. Apart from them, there are many other platforms to find non-conventional investment material.
Alternative investments are a working method of converting money into assets. Although they are deemed non-conventional and entail higher risks of loss, the potential return might also be higher.
To make the most of alternative investments, due diligence is key. The investor should look at a fund’s track record, investment horizon, and redemption and payback rules. Before investing, one must carefully study demand and supply and consider the various risks, such as potential illiquidity of an asset.
Most importantly, investments in alternative vehicles should always be viewed under the prisms of a well-diversified portfolio.