Alternative Investments: What Investors Need to Know

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Want to go beyond stocks, bonds and cash? Alternative investments can include everything from real estate to fine art. If you’re looking for another way to diversify your portfolio, alternative investments may be worth considering. Read on to discover if alternative investments make sense for your portfolio.

What is an Alternative Investment?

Alternative investments are assets that fall outside the traditional investment categories. Traditional investments include stocks, bonds, mutual funds or exchange-traded funds (ETFs). Alternative investments include venture capital or private equity, commodities, derivatives, currencies, structured settlements, managed futures, real estate, hedge funds and real assets such as art and antiques.

The reasons for moving into an alternative investments include a need to diversity a portfolio, specific tax incentives or an unusual opportunity to take advantage of a deeply discounted asset.

Typically, alternative investments have no correlation to conventional investments. This can make them difficult to value. They are also illiquid in comparison to traditional assets.  For instance, it may be more of a challenge to sell a piece of art than 500 shares of Amazon. It’s also difficult to actually value these assets since there are many considerations when determining each individual asset’s value.

Usually, institutional investors or accredited investors with a high net worth hold alternative investments because of their complexities, level of risk and deficiency of regulation. Recently, these investments have grown in popularity because institutional investors, which include pension and endowment funds, are increasing their investments in alternative options. They are doing so due to the potential long-term perks of this asset class.

It’s important to note that many alternative investments have high minimums and fee structures in comparison to mutual funds or ETFs. They also have fewer published performance data. While alternative investments have high fees and high minimums they tend to have lower transactional costs. This is because there is less turnover for the investment.

Types of Alternative Investments

Now that you have a basic understanding of what alternative investments may offer your portfolio, here are a few you may want to become more familiar with.

Private Equity

Private equity composition consists of funds or investors that invest in private companies. These companies include start-ups and venture capital and help with financing through the growth of an organization. These investments can encompass a broad array of  private equity markets. Private equity firms will typically raise funds from institutional and non-institutional investors, which they can then use to invest in a specific investment strategy or private firm.

Investors profit when an exit event occurs, such as an IPO or acquisition. They will receive the amount left over after the private equity firm takes their management and performance fees.

Venture Capital

Venture capital is a subset of private equity that specializes in investing in the early, or growth phase, of a company. A firm will raise funds from high net worth or institutional investors to then invest in companies that are at different funding stages. Venture capital is extremely important to start-ups and companies in their early funding stages because they have no revenue or little to no operational history.

Funding this type of investment can be a risky endeavor but it can yield high returns: Investors who put money into Google, Facebook and Twitter have enjoyed exceptional returns.

Start-up and private firm investing

Instead of investing in private equity firms, investors can invest directly in start-ups or private firms. This type of investing is sometimes referred to as angel investing. Angel investing is a high-risk, high-reward investment strategy since not all start-ups succeed.

If a private company needs some form of direct investment it will seek investors through private placement. This placement can proceed only if the investment meets certain criteria. Retail investors can also participate depending on the type of registration exclusion the firm relies on.

Hedge Funds

A hedge fund is an investment partnership that pools assets from all investors involved. Hedge fund managers raise capital to invest in different financial instruments and strategies. Hedge funds are different from private equity and venture capital investments because they tend to invest in public equities, which means investors can distribute their funds more often.

Tangible assets

Tangible or real assets hold inherent value. These assets can include oil, precious metals, commodities and land. Tangible assets also include collectible items such as art, antiques, baseball cards, wine, jewelry and rare coins — even water. Investors can either purchase real assets directly or they can invest in funds such as SPDR Gold Trust (NYSEMKT:GLD).

Real estate

Real estate investment trusts (REITs) enable the retail investor to benefit from the rising value of residential or commercial property. A REIT is a company that either owns income-producing properties or owns the mortgage on those properties. Typically, REITs specialize in a certain type of property, although you can also find hybrid trusts that offer a mix of investments. The REIT sells shares to investors, which you can purchase directly from the company or through an exchange-traded fund (ETF) or mutual fund.

Additional Considerations

Due to the lack of regulation of alternative investments, some investments are prone to scams and fraud. In comparison to traditional investments, alternative investments have fewer legal boundaries and structure.

While most alternative investments fall under the Dodd- Frank Wall Stress Reform and Consume Protection Act, they usually don’t have to register with the Securities and Exchange Commission (SEC). However, they are subject to examination by the SEC. Yet, they are not overseen or regulated the way mutual funds and ETFs are. Therefore, it’s imperative that investors do their due diligence when considering alternative investments.

Another consideration is that these investments have low correlation to stocks, bonds, mutual funds or other conventional investments. This means that these investments move counter to or in the opposite way of conventional securities. That feature makes them suitable for increasing your diversification within a portfolio. Tangible assets such as precious metals, oil or real estate also help the investor hedge against inflation.

How to Invest In Alternative Investments

While many alternative investments are often limited to accredited investors, institutional investors or those with high net worth, there are also options for non-accredited investors. Alternative mutual funds or ETFs are available for individual investors. Since most alternative investments are costly and difficult to invest in, these funds provide access to alternative investment categories for average investors.

Since they are publicly traded, there is a requirement for registration with the SEC and they’re regulated by the Investment Company Act of 1940. If you’re interested in investing in alternative investments, speak with your financial advisor to discover all of the options available.

The Bottom Line

For the most part, alternative investments appeal to serious and accredited investors. They often require a lot of money upfront and can carry substantial risks. Alternative investments don’t always pay off, but when they’re successful they can generate large returns much faster than publicly traded stocks.

If you don’t have the capital to invest in alternative investments directly, you may want to consider alternative mutual funds or ETFs. Before investing in an alternative investment, make sure to do your due diligence or even consult with your financial advisor.

Tips for Investors
  • While the high-stakes, high-dollar world of alternative investments might not be practical for you, a financial advisor can help you vet various options and also put together a more traditional investing plan. Finding the right financial advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to find a match among your local advisors who will help you achieve your financial goals, get started now.
  • Understanding your risk tolerance and investing goals is a key part of any long-term financial strategy. Take advantage of Smart Asset’s Investment Calculator to better visualize your goals and preferences.

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