What are alternative investments? How can alternative investments improve your portfolio?

WHAT IS THE ALTERNATIVE WHY ALTS

Alternative investments, or ALTs, are gaining popularity among investors as promising ways to generate income, increase returns, and diversify portfolios. However, it is understandable if you don't know what an alternative investment is because the term is very general. Over the next five to ten minutes, this article will help you better understand alternative investments and how they apply to investment strategy and wealth building.

What Is an Alternative Investment?

Also known as alternative assets, alternative investments are financial assets that fall outside the mainstream asset classes, such as stocks, bonds, and cash. The alternative asset class encompasses a broad range of diverse, unregistered investments. As a result, thoroughly investigating assets in this category is challenging. However, individual and retail investors are gaining more access to alternative investments.
Global alternative assets under management reached $10 trillion in 2020¹. And experts project that the volume will increase to $14 trillion by 2027². As a result, alternative assets are increasingly being included in more investment portfolios worldwide.

What are Some Alternative Investment Types?

Most investors gain exposure to institutional-quality alternative assets through four primary types.

• Private Equity
  With a 36% share ($6.5 trillion) of the $18 trillion in alternative assets, private equity is the largest category of all alt investments ³. Private equity involves an investment of capital in private companies that are not available for trade on the NYSE, NASDAQ, or any public exchange. The capital investment may be venture capital, growth capital, or buyouts.
• Real Assets
  Tangible Assets encompass many asset classes, including real estate, farmland, natural resources like oil and iron ore, commodities, collectibles, intellectual property, and infrastructure.
• Hedge Funds
  Hedge funds feature highly skilled, experienced fund managers who can use complex and often risky strategies to achieve higher returns. These private, pooled funds are exclusively available to sophisticated investors like mutual funds, pension funds, endowments, and high-net-worth individual investors (accredited investors).
  
  Learn more about What is an Accredited Investor?
  
  
• Structured Products
  Also known as market-linked investments, structured products are pre-packaged structured investments linked to fixed-income markets that yield dividends from a basket of securities, market indices, bonds, or derivatives. For example, credit default swaps (CDS) and collateralized debt obligations (CDO) are structured products⁴.

Why invest in alternative investments?

Although alternative investments can vary significantly in nature and protocol, they share some commonalities that could benefit your investment portfolio. These advantages include the following:

• Less volatility.
  Alts investments have less exposure to the major markets, making them less sensitive to market volatility⁵.
• Low market correlation.
  Low correlation to traditional asset classes is a dominant selling point for alternative investment solutions. For example, real estate performance is largely separate from the equity market.

• Possible greater returns.
  Alts investments offer higher returns as compensation for taking higher risks. Alternative investments can generate higher returns than traditional investments because of their unique risk-return profiles. For example, private equity investments may provide higher returns than publicly traded stocks because of their illiquidity and active portfolio management.

• Hedges against inflation.
  Real estate, oil, and gold are alternative investments that can serve as potential inflation hedges. Alternative investments, such as real estate, commodities, and infrastructure, may offer inflation protection because of their tangible assets and/or ability to generate cash flows that can increase with inflation.
• Diversification.
  Since alternatives have a low correlation to stocks and bonds, you can improve diversification in your portfolio by adding an alternative asset solution. Alternative investments such as real estate, private equity, and hedge funds can support diversification by offering exposure to asset classes and strategies different from traditional investments like stocks and bonds. This diversification can help reduce overall portfolio risk by spreading investments across different asset types with low correlations.
• Access to unique investment opportunities.
  Alternative investments can offer access to opportunities not available through traditional investments. For example, investing in a start-up company through venture capital can provide exposure to innovative technologies and potentially high-growth companies that may not yet be publicly traded. Alternative investments typically have higher fees and require more due diligence than traditional investments. Investors should consider their investment objectives, risk tolerance, and overall portfolio before investing in alternative investments.

What are Some Alternative Investment Drawbacks?

Like any asset class, alt investments come with their unique cautionary characteristics. Two of the most prominent concerns are limited regulation and transparency.
Since the SEC doesn't regulate most alternatives, this can restrain the information available to investors. However, alt investments fall under the Dodd-Frank Act, which gives the SEC authority to review their practices.

Another thing to keep in mind is that many alternative assets are illiquid. Because most are not publicly traded, many alternatives don't have a regular market price, making it difficult to determine value for buying or selling. This dilemma is why many hedge and private equity funds set defined periods that prohibit withdrawals. In addition, the higher risk factor may be too much for some investors.

How to Buy Alternative Assets?

As you can see, buying alternative investments is more involved than purchasing traditional asset classes. Of course, the higher return potential and keen diversification are desirable attributes. But the risks can be sobering. As a result, if you aspire to venture into alternative investment solutions, you must commit to many hours of due diligence and exhaustive research.
If you are an accredited investor, investing through an investment firm specializing in alternative investment strategies backed by real estate, farmland, or commodities may be more advantageous. These firms generally have the expertise to properly study and evaluate the risk/return potential to provide an alternative investment portfolio solution or investment strategy.

FAQs

What are some examples of alternative investments?

Alternative investments offer individual and institutional investors viable opportunities for building wealth. The most popular alternative assets are

• real estate investing,
• venture capital,
• private equity,
• intellectual property,
• farmland,
• and collectibles, such as art and rare coins.

What is the best alternative investment?

Generally, real estate is the best alternative investment for several reasons.

• It provides the potential for high returns and
• low correlation to traditional investment assets like stocks and bonds.
• However, real estate is more transparent and regulated than most alternative assets.

Who can invest in alternative investment funds?

Alternative investment funds are exclusively available to high-net-worth individuals and institutional investors. A high-net-worth investor has an accredited investor designation by the Securities and Exchange Commission (SEC). To become an accredited investor, you must demonstrate a net worth of over $1 million, excluding your home. Alternatively, you can qualify by verifying that you have a valid financial professional license or an annual income of at least $200,000 over the past two years, or $300,000 as part of a couple.

Is private equity an alternative investment?

Yes, private equity is considered an alternative investment.
Private equity investments typically involve investing in a company to enhance its operations and financial performance, ultimately increasing its value. Private equity investments are often illiquid, making it challenging to sell or transfer ownership before the intended exit date. Private equity investments can also be riskier than traditional investments because they concentrate risk in a single company and lack market liquidity.

Private equity investments can diversify an investor's portfolio by offering exposure to an asset class distinct from traditional investments. Private equity investments can also generate higher returns than traditional investments, thanks to private equity firms' ability to actively manage portfolio companies and improve their financial performance.

Sources
1. PWC https://www.pwc.com/jg/en/publications/alternative-asset-management-2020.pdf 
2. Preqin https://docs.preqin.com/reports/Preqin-Future-of-Alternatives-Report-October-2018.pdf 
3. Caia https://caia.org/blog/2022/04/06/state-alternative-investments-2022 
4. HBS https://online.hbs.edu/blog/post/types-of-alternative-investments 
5. Forbes https://www.forbes.com/advisor/investing/alternative-investments/ 
6. Forbes https://www.forbes.com/sites/forbesbusinesscouncil/2021/12/15/understanding-the-upsurge-of-alternative-investments/?sh=709112524b0e