What are Alternative Investments?

Alternative investments are investments that don’t easily fall into one of the standard predefined investment categories (like stocks, mutual funds and bonds). Alternative investments typically have much higher levels of both risk and reward, and they typically come with higher investment minimums. Due to their higher degree of risk and lower levels of regulation, most alternative investments are held by high-value accredited investors.

While alternative investments may have additional barriers to entry, they can be used to add another layer of portfolio diversity to your holdings. Today, we’ll explore some of the most common alternative investments and explore investment strategies. 

Understanding the Types of Alternative Investments

There are multiple types of alternative investments, ranging from privately-managed hedge funds to diverse real estate investments. The specific type of investment you choose will dictate your risk level and minimum required investment.  

Art and Collectibles

Art and collectibles encompass a wide range of items that can be considered alternative investments. These items include rare wines, vintage cars, fine art, mint-condition toys, stamps, coins and baseball cards, among others.

Investing in collectibles can be an exciting venture, as it allows you to combine your passion for hobbies with the potential for long-term financial gain. However, it is important to be aware of the potential risks that come along with these investments.

One of the main risks associated with investing in collectibles is the high acquisition costs. Rare and valuable items often come with a hefty price tag, making it necessary for investors to have a substantial amount of capital to participate in this market. Additionally, these items may not generate any income until they are sold, meaning that investors may need to wait years before making a return on their investment.

Another crucial aspect to consider is proper storage and care for these items. Collectibles, especially those made of delicate materials like paper or fabrics, require specific conditions to maintain their value. Factors such as exposure to light, humidity, or temperature fluctuations can have a detrimental impact on the item's condition, potentially lowering its value.

Hedge Funds

A hedge fund is a type of investment fund that is able to invest in many more types of assets when compared to standard mutual funds. Hedge fund managers may choose to split investment funds between assets like stocks, commodities, derivatives, futures, options and other financial instruments that standard mutual fund managers cannot invest in due to regulations set by the Securities and Exchange Commission (SEC). This broad leeway often brings positive returns for investors, but minimum investments are almost always $500,000 or higher.

Bridgewater Associates offers some of the world’s largest hedge funds, totaling billions of dollars’ worth of assets under its control. The company’s flagship “Pure Alpha” hedge fund invests in 30 to 40 trading positions in bonds, currencies, stock indexes and commodities through active management. 

Real Estate Property

Real estate (the purchase of land, often with a home or building) is also often classified as an alternative investment. Direct real estate investors can earn money in one of two ways:

• Purchasing and selling the property at a profit: You can purchase a property and sell it in the future as property values rise. Some investors purchase properties in need of repairs, perform the repairs themselves and sell the property after construction is complete for a faster profit.
• Renting the property: You can purchase a property and rent it out to tenants in exchange for a monthly rental fee.

You can also invest in the real estate market indirectly through the purchase of a real estate stock or exchange-traded fund (ETF), a limited real estate partnership or a real estate investment trust (REIT).

Apple Hospitality REIT, Inc. (NYSE: APLE) is an example of a REIT. The company focuses on using investor funds to purchase upscale hotels. Apple Hospitality then redistributes a portion of its earnings back to investors in the form of dividends. 

Private Equity

Private equity is ownership in a company that isn’t publicly traded through shares of stock. You can purchase private equity directly through a company seeking startup capital or by pooling your funds with other investors via a private equity firm. Investors who own private equity often have a strong hand in directing the management and activities of the companies they fund.

Diamond Castle Holdings is an example of a private equity firm focused on leveraged buyouts and growth capital of middle-market companies. Most of its investments have been in the financial, energy and healthcare sectors.  

Cryptocurrencies

Investing in cryptocurrencies has gained significant attention in recent years due to their unique characteristics and potential as an alternative investment outside traditional stocks and bonds. These digital assets are typically decentralized, meaning they are not controlled by a central authority such as a government or financial institution.

One notable feature of cryptocurrencies is their potential to function as a store of value. Unlike traditional currencies which are subject to inflation, cryptocurrencies often have a limited supply, which could make them a hedge against inflation. Additionally, the blockchain technology behind cryptocurrencies allows for secure and transparent transactions, further enhancing their value as a digital store of wealth.

It's important to note that cryptocurrencies are notoriously volatile in nature. Their value can fluctuate dramatically within short periods, driven by various factors such as market sentiment, regulatory developments, and technological advancements. This volatility can pose significant risks to investors, as the potential for substantial gains is countered by the possibility of significant losses.

Peer-to-Peer Lending

Peer-to-peer lending is a form of debt investing that allows individuals to lend money directly to borrowers without the intermediation of traditional financial institutions. There are several different forms of debt investing within the realm of P2P lending.

The most common form is unsecured personal loans, where individuals lend money to borrowers for various purposes such as debt consolidation, home improvements or business funding. These loans typically have fixed interest rates and repayment terms.

Another form of P2P lending is business loans, where investors provide funding to small and medium-sized enterprises. These loans can be secured or unsecured, and investors can choose the businesses they want to lend to based on their risk appetite and investment criteria.

While P2P lending offers the potential for higher returns compared to traditional savings accounts or fixed-income investments, it also comes with certain risks. The main risk is the possibility of borrower default, where the borrower fails to make scheduled loan repayments. Delinquencies and defaults can result in a loss of principal and interest for the investor.

To mitigate these risks, P2P lending platforms often implement credit underwriting processes and risk assessment models to evaluate the creditworthiness of borrowers. However, there is still a chance of default, especially during economic downturns or financial instability.

Commodities 

A commodity is a raw material that can be traded, bought or sold. Some examples of commonly traded commodities include:

• Precious metals (gold, silver, platinum)
• Fossil fuels (like oil, natural gas and coal)
• Crops (rice, coffee, sugar)

Commodities can be a particularly volatile investment because the prices of commodities fluctuate based on unpredictable events and natural disasters. For example, imagine that a tsunami wipes out a large crop of rice one year. The price of rice would likely skyrocket, as demand remains high but the amount of available products stays low. However, the next year, farmers might attempt to capitalize on this price gap by growing more rice. Assuming another natural disaster doesn’t strike, this would cause the price of rice to plummet as supply outweighs demand.

A safer way to invest in commodities is to invest in a commodity ETF instead of individual commodities. Commodity ETF managers typically invest in a wide range of commodities to prevent excessive loss. 

Alternative Investment Strategies

Alternative investments have traditionally had low correlation rates with the overall market at large. This means that in years when the market goes down, the value of alternative investments typically goes up. This means that alternative investments can provide a unique level of diversification to your portfolio. Certain hard assets (like gold and property) can also provide a hedge against inflation.

While alternative investments are often valued because they go against the traditional market, this can also make them a riskier bet for your portfolio. Most institutional investors allocate a very small percentage of their overall assets to alternative investments — on average, 10% or less. If you do decide to add an alternative investment to your portfolio, keep your initial purchase modest and only use these assets as a complement to a portfolio otherwise composed of well-performing mutual funds, ETF and total market index funds. 

Pros and Cons of Alternative Investments

Like any other investment, alternative investments have their own unique benefits and drawbacks. Understanding both the pros and cons that come with alternative investments is crucial. 

Pros:

• More potential for profits: Alternative investment managers can often take risks that standard investment managers who oversee assets with strict SEC regulations cannot. If the investment turns out to be successful, it can compound returns.
• Additional portfolio diversification: Alternative investments add a unique layer of diversification to your portfolio. This can help protect your investments in the case of a recession or period of his market volatility.
• Often work counter to the larger market: The value of alternative investments tends to increase when the overall market is bearish. Alternative investments can provide a unique hedge against a market downturn.

Cons:

• Higher risk: Though alternative investments’ lack of SEC regulation can work to your advantage, it can also mean greater loss if you make a bad investment.
• Less liquid: If you have an emergency bill that you need to cover quickly, you typically won’t run into much trouble if you are forced to sell your mutual funds, stocks or ETFs. Liquidating an alternative investment can be a more time-consuming and intensive process, as buyers typically aren’t readily available when compared to standard investments.
• Higher entry point. To get started with an alternative investment, you’ll typically need a large amount of capital or to already be an accredited investor. This high barrier of entry can make alternative investments significantly more difficult to access. 

Best Brokers for Other Alternative Investments

There are also many specialty brokers offering easier access to varying types of alternative investments. Below, you’ll find a sample of some of our favorite specialty brokers and what they do best.

Getting Started With Alternative Investments

According to the SEC, many alternative investment funds formed after the year 2008. This means that there is limited data on how these investments will perform during a recession or bear market, making them riskier than traditional investments with long histories. If you do decide to add an alternative investment to your portfolio, be sure to thoroughly research the investment’s manager, investment strategy and goals. This will help you avoid financial loss and will help you make the most out of your new investment. 

Frequently Asked Questions