Alternative Investments Explained. How to invest. Types of Alts.

Discover the unique potential of alternative investments with Paperfree.com. Explore diverse asset classes and strategies, enhance your portfolio diversification, and learn about the advantages and risks.

last updated Friday, June 21, 2024
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John Burson

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Delve into alternative investments and uncover their unique potential with Paperfree.com. Explore diverse asset classes and strategies that make up alternative investments, bolster your portfolio diversification, and discover how these options can enhance your financial prospects.

This comprehensive guide gives insights into alternative investments' advantages, risks, and critical insights.

Significant shifts in geopolitics, economic trends, and consumer behavior have made the markets increasingly complex and unpredictable. For this reason, many investors are replacing traditional investment options like stocks and bonds with alternative investments in their portfolios or at least adding alternatives to the mix.

Alternative investments include diverse opportunities like real estate, private equity, commodities, and hedge funds. These non-traditional assets have gained popularity in the investment community for several compelling reasons. However, successful investing in alternative investments can be challenging for even the most experienced investors.

In this comprehensive guide to alternative investments, we will:

• Clearly define alternative investments
• Demystify the intricacies of these asset classes
• List the different types of alternative investments
• Explain regulatory powers over alternatives
• Detail the advantages and disadvantages
• Explain how to invest in several alternative investments
• Discuss the tax implications and regulatory standards
• Describe the characteristics of alternative investments along with their value to investors.

What Is an Alternative Investment?

Alternative investments can be any asset class that doesn’t classify as traditional assets, such as stocks, bonds, and mutual funds. These assets are also available for trade on platforms other than public markets. 

In the past, alternative investments were primarily options for wealthy or institutional investors. However, technology and more accessibility have encouraged increased trading activity of alternative assets by investors of all types.

Understanding Alternative Investments

Although alternative investment assets have gained prominence among all types of investors, most of these assets remain in the hands of accredited, high-net-worth people or institutional investors. The reasons for this disparity include high initial investment requirements, low exposure, and the need for more transparency for most alt investments. 

In many cases, finding verifiable performance information like you get with stocks, bonds, and mutual funds is very challenging. And many alternatives are not subject to government regulation. These conditions are why alternative investments typically attract more sophisticated investors.

Types of Alternative Investments

Although alternative investments share these characteristics, they belong to a diverse asset class. Each has its unique terminology and protocols. Here is a list of nine types of alternative investments. 

1. Real Estate as an Alt.
   This type of alternative investment involves investing in physical properties or property-based securities [1]. This includes real estate investment trusts (REITs), crowdfunding platforms, and real estate funds. Along with seeking capital appreciation of tangible assets, a real estate investment strategy aims to generate consistent cash flow from operating income.
2. Art and Collectibles as Alternatives.
   Art and collectibles can give investors a way to match their hobbies or recreational interests with their investment activities. Some of the categories for these assets include sports memorabilia, art, rare coins, or other collectibles as an alternative investment [2]. Primarily, investors assess the worth of a piece of art or a collectible by its historical value and relation to a famous person or event.
3. Private Equity / Venture Capital as an Alternatives.
   It’s easy to mistake private equity as a traditional investment because investors acquire partial company ownership by buying its stock. However, private equity investors purchase stock in companies not listed on public exchanges, such as the Standard and Poor (S&P) 500. Therefore, the private companies they invest in are not SEC-regulated, and they have the other characteristics of alt investments, such as illiquidity, low correlation to other assets, etc. The relationship between an investing firm and the company in the investment venture is vital to private equity. Since the private equity company typically guides the firms, the company’s leaders must respect the private equity partners’ mentorship capabilities, industry expertise, and judgment of talent. Several subcategories of private equity include:
   1. Venture capital.
      Invest in start-ups and companies in the early stages.
   2. Growth capital.
      Provide capital for mature companies planning to expand or restructure
   3. Buyouts.
      Completely purchases a company or one of its divisions
4. Commodities.
   Commodities are tangible assets derived from natural sources, such as oil, natural gas, gold, agricultural products, and precious metals. Since commodities have essential uses, they attract investors with the perpetual demand for their properties.  For example, oil prices are usually stable because of their widespread use in almost every industry, making them insensitive to the public equity market. For this reason, experts consider commodities a hedge against inflation and an excellent asset for portfolio diversification.
5. Private Debt.
   Private debt is an alternative investment that involves private investors lending money to companies for growth or restructuring. No banks or publicly traded debt vehicles are involved. However, private and public companies can borrow money through private debt. Private investors invest in debt through a private debt fund with the projection of making money through interest payments and repayment of the initial loan.
6. Farmland.
   Farmland is not just another type of real estate as an investment. Instead, it is a blend of real estate and commodities. This distinction means you receive the benefits of tangible land and the potential income from the operations and sale of commodities, such as chickens, crops, or livestock. There is also the possibility of earning money from water or mineral rights in certain regions.
7. Hedge Funds.
   Hedge funds are investment funds that earn a high return on investment (ROI). Hedge fund managers trade relatively liquid assets using various investment strategies. They are highly skilled investors with the elite ability to execute their strategies, such as market neutral, long-short equity, quantitative, and growth strategies. Since hedge funds require a hefty minimum investment and keen investor insight, they are exclusive alternative investments available to pension funds, high-net-worth individuals, endowments, and other institutional investors.
8. Structured Products.
   Except for being a private investment, structured products function like other fixed-income investments like government bonds or derivatives. Some popular structured products are credit default swaps (CDS) and collateralized debt obligations (CDO). Although structured products can be complicated and risky, you can get a customized product mix to suit your needs. Investment banks typically create structured funds for retail investors, hedge funds, and organizations.
9. Peer-to-Peer Lending.
   Peer-to-peer lending is the process of investors granting loans to individuals or businesses via online platforms where borrowers and investors can connect and make deals. Although similar to investing with bonds, this alternative investment occurs in more private markets, and the clients are riskier. For these reasons, peer-to-peer lending has a higher return potential than traditional investments. In addition, some online platforms offer accessibility to retail investors. 

Regulation of Alternative Investments

Unfortunately, the lack of regulations on alternative investments increases the potential for fraud and scams in this asset category. It can create barriers to investors getting accurate information about alternative investments. 

This is the case despite alternative investments being under the governance of the Dodd-Frank Wall Street Reform and Consumer Protection Act [3] and being subject to U.S. Security and Exchange Commission (SEC) scrutiny. However, the SEC doesn’t require them to register with the regulator agency. So, the SEC does not regulate alternative investments like stocks and bonds.

Due to the lack of regulation, people dealing with alternative investments must conduct thorough due diligence and possess sophisticated investing experience. This requirement is why some alternative investment offerings are available to accredited investors. 

An accredited investor is a classification for a person with a net worth of past $1 million (minus the primary residence) or earnings of at least $200,000 per year — $300,000 combined income with a spouse. Also, financial professionals with a FINRA series 7, 65, or 82 are eligible to be an accredited investor.

Advantages and Disadvantages of Alt Investments

Alternative Investment Advantages

The following advantages contribute to the popularity of alternative investments.

1. Diversification.
   As mentioned earlier, alternative investments have a low correlation with stocks, bonds, and other traditional asset classes. You can use them to diversify your portfolio, reducing overall portfolio risk. They may continue to generate positive returns when the market underperforms, providing a hedge against market dips.
2. Potential for High Returns.
   Private equity, venture capital, and certain hedge funds have exceptional potential to deliver above-average returns. Although these alternative investments have higher risk levels, they can provide enormous rewards for risk-neutral investors [4].
3. Inflation Hedge.
   Real Estate, commodities, and other alternative investments can be effective hedges against inflation when the prices of goods and services increase. Instead of tracking the public market, the value of these assets may also rise, helping to preserve your purchasing power.
4. Limited Market Volatility.
   Private equity and direct investment in private companies rarely react to daily market fluctuations. Alternative investments are excellent options for more stability in a volatile investment market.
5. Portfolio Customization.
   Alternative investment allows you to adjust your portfolio to specific goals and risk tolerances. Whether you prefer a stable income, capital appreciation, or a mixture of both, alternative assets offer various options to sync with your investment strategies.

Alternative Investment Disadvantages

You should be aware of these disadvantages before venturing into alternative investments. 

1. Limited Investor Access.
   Many alternative investments have higher fees and expenses than traditional investments. Unlike many free stock and bond trades brokers offer, most private equity and hedge funds charge high management and performance fees. This practice can reduce investors’ returns on these alternative investments.
2. Complexity.
   The complexity of many alternative investments can baffle the average investor. As a result, the intricate strategies, structures, and contractual details can make it challenging for investors, even for more experienced investors, to assess their risk and potential returns.   
3. Limited Transparency.
   Many alternative investments need more transparency of publicly traded assets. Due to the nature of alternative assets, investors often need more access to information about the underlying holdings or strategies of many alternative funds, making it difficult to assess risk.
4. High Risk of Loss.
   Although they may offer potentially high returns, alternative investments also pose a higher risk of loss.  Leverage buyouts, distressed investing, and venture capital are especially risky strategies capable of causing you to lose some or all of your capital.
5. Illiquidity.
   Lack of transparency, limited information about the assets, small market size, and strict deal structures are the primary reasons alternative assets are less convertible to bonds and cash than traditional ones. Most of the time, you should prepare for the remaining money in the investment for an extended period. 

How to Invest in Alternative Investments?

Alternative investments are much less accessible in today’s financial markets than in the past. However, investing in alternative investments differs from investing in traditional assets like stocks and bonds. 

Some may be more suitable for accredited investors who can provide substantial capital and conduct expert-level research. Others only require navigating an online platform. Either way, this is how to begin investing in several alternative investments. 

1. Real Estate.
   There are various ways to invest in real estate, including Real Estate Investment Trusts (REITs), buying rental properties, real estate crowdfunding platforms, or real estate funds.
2. Private Equity.
   When you buy shares in a company or groups of companies outside of the public markets, you are making a private equity investment. You can execute this type of stock purchase through private equity firms, crowdfunding platforms, and venture capital funds.
3. Commodities.
   A commodity investment occurs when you purchase a hard asset, such as gold, silver, and other tangible goods of value. You can do it independently or join in commodity investments through exchange-traded funds (ETFs), commodity trading platforms, or mutual funds.
4. Art and Collectibles.
   You can invest in arts and collectibles in several venues, including auction houses, art dealers, and online platforms. Remember, the value of these alternative investments is their uniqueness. So, you should investigate the authenticity of the items or invest through a creditable dealer. 

What are the Tax Implications of Alternative Investment?

Since alternative investments belong to a completely different asset class than traditional investments, their tax rules are unique. The primary difference tax-wise is alternatives can have different income streams. For example, suppose you have rental property. You can potentially receive capital gain on the sale of the property and collect rental income. 

Collectibles, art, and other alternative investments may not feature similar tax deductions as stocks and bonds. In addition, art, coins, and similar collectibles fall into the strict IRS classification for collectibles, resulting in a maximum 28% tax on net capital gains. 

On the other hand, real estate and specific types of energy investments may feature tax-free or tax-deferred opportunities. For example, your investment may include 1031 exchanges or Opportunity Zone tax breaks [5]. You can avoid paying taxes with these investments by using the proceeds from selling one alternative asset to invest in a like asset. 

What Are the Main Characteristics of Alternative Investments?

The U.S. Securities and Exchange Commission (SEC) lightly regulates most alternative investments, if at all. As a result, there’s little legal incentive for holders of alternative assets to be fully transparent. It is up to the investor to do thorough due diligence or be an expert in that market. For example, an investor would have less verifiable information when investing in a network of pig farms than in Amazon. 

Also, alternative investments don’t get the broad exposure and advertising that publicly traded assets receive. This means the investor must be more investigative or plugged into the market. However, online investment platforms have given these assets more exposure and availability to accredited and retail investors. 

Alternate assets are not subject to regular valuation,  and their markets are smaller than traditional assets. So, these assets can be challenging to sell or convert into cash. However, one of the alternative assets' primary qualities is their low correlation to conventional asset classes, meaning they react differently to changing market conditions.

How Can Alternative Investments Be Useful to Investors?

If you want to invest in assets that hold their value in a market downturn, alternative investment would be an excellent choice because of their low correlation to assets traded in the public market. In addition, gold, oil, real property, and other hard assets are potent hedges against inflation. These attributes are why pension funds, family offices, and other large financial institutions add diversity to their portfolios with alternative investments.  

Why Paperfree.com

A recurring theme in this article is that alternative investments exist in many uncharted territories. To mitigate the risk of loss or fraud, you must do extensive due diligence and work with trustworthy, experienced partners like Paperfree.com. 

Paperfree.com is a real estate investment platform that allows you to invest in potentially lucrative alternative investments. When you visit Paperfree’s online platform, you can browse through the real estate funds and managed collaborations you could partner with, regardless of whether you are an accredited or non-accredited investor.  

Sources

[1] How Do Real Estate Hedge Funds https://www.investopedia.com/ask/answers/110215/how-do-real-estate-hedge-funds-work.asp
[2] 7 Types of collectibles https://www.businessinsider.com/personal-finance/collectible-investments-valuable-types
[3] Congress. GOV. https://www.congress.gov/bill/111th-congress/house-bill/4173/text
[4] What is Risk Neutral?  https://www.investopedia.com/terms/r/riskneutral.asp
[5] What is a 1031 Exchange? https://www.investopedia.com/financial-edge/0110/10-things-to-know-about-1031-exchanges.aspx

 
 
 

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