Beyond Traditional Asset Classes: Exploring Investment AlternativesSubmitted by MIRUS Financial Partners on July 27th, 2018
Stocks, bonds, and cash are fundamental components of an investment portfolio. However, many other investments can be used to try to spice up returns or reduce overall portfolio risk. These “alternative assets” have become popular in recent years as a way to provide greater diversification.
What is an alternative asset?
The term "alternative asset" is pretty flexible; it can refer to anything for which investment performance is not correlated with that of stocks and bonds. It may include physical assets, such as precious metals, real estate, or commodities. In some cases, geographic regions, such as emerging global markets, are considered alternative assets. Complex, new, or otherwise unusual methods also qualify.
For example, a hedge fund might be considered an alternative asset because it uses investment techniques that are off-limits for most mutual funds. Private equity investments can also be considered alternative assets because they rely on certain highly-specialized skills in selecting and managing specific businesses. Collectibles are included in this category because the value of the investment depends on the unique properties of a specific item as well as general interest in that type of collectible.
Each alternative asset type involves its own unique risks and may not be suitable for all investors. Because of the complexities of these various markets, it’s smart to consult your financial advisor or other expert guidance before you make alternative assets a significant part of your investment portfolio.
Hedge funds are alternative assets
Hedge funds are private investment vehicles that manage money for institutions and wealthy individuals. They are usually organized as limited partnerships, with the fund managers as general partners and the investors as limited partners. The general partner may receive a percentage of the assets, fees based on performance, or both.
Hedge funds originally derived their name from their ability to hedge against a market downturn by selling short. Though they may invest in stocks and bonds, hedge funds are considered an alternative asset class because of their unique, proprietary investing strategies, which may include pairs trading, long-short strategies, and use of leverage and derivatives. Participation in hedge funds is typically limited to accredited investors who must meet SEC-mandated high levels of net worth and ongoing income. Individual funds also usually require very high minimum investments.
Note: If you do not qualify to invest directly in a hedge fund, you may be able to find a fund that invests in multiple hedge funds and requires a lower minimum investment, though that minimum usually is still
higher than most mutual-fund minimums. By investing in multiple investing styles, managers, and strategies, a fund of funds may provide greater diversification than a single hedge fund. Be aware that a fund of funds may or may not be registered with the SEC; be sure to check. Even if it is registered, any SEC protections apply only to the fund of funds, not necessarily to the underlying funds in which it invests. Also, you will pay fees charged by both the fund of funds and each underlying fund.
Private equity/venture capital are alternative assets
Like stock shares, private equity and venture capital represent an ownership interest in one or more companies, but firms that make private equity investments may or may not be listed or traded on a public market or exchange.
Private equity firms often are involved directly with the management of the businesses in which they invest.
If you’re considering investing in private equity you should take a long-term view. Not all investments provide returns. Investments that do pay off may take years to produce any meaningful cash flow. In fact, many funds require a 10-year commitment. Like hedge funds, private equity funds also typically requires a large investment and are available only to investors who meet high SEC net worth and income requirements.
Real estate is an alternative investment
Real estate investments usually require you to make direct or indirect investments in buildings--either commercial or residential--and/or land. Direct investment involves the purchase, improvement, and/or rental of property. Indirect investments are made through an entity that invests in property, such as a real estate investment trust (REIT), which may be either publicly traded or not. Real estate not only has a relatively low correlation with the behavior of the stock market but also is often viewed as a hedge against inflation.
Precious metals are an alternative investment
Investors have traditionally purchased precious metals because they believed that gold, silver, and platinum provide security in times of economic and social upheaval. Gold, for instance, has historically been seen as an alternative to paper currency and therefore is sometimes used in portfolios to hedge against inflation and currency fluctuations. As a result, gold prices often rise quickly when investors are worried that the dollar is losing value. Conversely, the value of precious metal can fall just as quickly.
There are many ways to invest in precious metals. In addition to buying bullion or coins, you can invest in futures, shares of mining companies, sector funds, and exchange-traded funds (ETFs).
Natural resources and equipment leasing is an alternative investment
Direct investments in natural resources, such as timber, oil, or natural gas, can be done through limited partnerships that provide income from the resources produced. In some cases, such as timber, the resource replenishes itself; in other cases, such as oil or natural gas, it may be depleted over time. Timberland also may be converted for use as a real estate development.
Some limited partnerships pool your money with that of other investors to invest in equipment leasing businesses, giving you partial ownership of the equipment those businesses lease out, such as construction equipment.
Commodities and financial futures are alternative investments
Commodities are physical substances that are fundamental to creating other products or to commerce generally. Commodities are basically indistinguishable from one another. Examples include oil and natural gas; agricultural products such as corn, wheat, and soybeans; livestock such as cattle and hogs; and metals such as copper and zinc.
Commodities are typically traded through futures contracts, which promise delivery on a certain date at a specified price. Futures contracts also are available for financial instruments, such as a security, a stock index, or a currency. Though the futures market was created to facilitate trading among companies that produce, own, or use commodities in their businesses, futures contracts also are bought and sold as investments in themselves, and some mutual funds and ETFs are based on futures indexes.
Futures allow an investor to leverage a relatively small amount of capital. However, they are highly speculative, and that leverage also magnifies the potential loss if the market does not behave as expected.
Art, antiques, gems, and collectibles are alternative investments
Some investors are drawn to these categories because art, antiques, gems, and other collectibles may retain their value or even appreciate as inflation rises. However, those values can be unpredictable because they are affected by supply and demand, economic conditions, and the quality of an individual piece or collection.
Why invest in alternative asset classes?
Part of sound portfolio management is diversifying investments so that if one type of investment is performing poorly, another may be doing well. As previously indicated, returns on some alternative investments are based on factors unique to a specific investment. Also, the asset class as a whole may behave differently from stocks or bonds.
An alternative asset's lack of correlation with other types of investments gives it potential to increase or stabilize a portfolio's return. As a result, alternative assets can complement more traditional asset classes and provide an additional layer of diversification for money that is not part of your core portfolio, although diversification cannot guarantee a profit or ensure against a loss.
Make sure you understand the investment tradeoffs
While alternative investments present many interesting investment opportunities, they are less popular than investments because of the tradeoffs. Alternative assets may be less liquid than stock or bonds. Depending on the investment, there may be restrictions on when you can sell, and when you’re ready to sell, you may or may not be able to find a buyer. Because some of these alternative assets are not regulated in the same way as traditional investments, performance, values, and risks may be difficult to research and assess accurately. It’s also challenging for many people to qualify for direct investment in hedge funds or private equity.
The unique properties of alternative asset classes also mean that they can involve a high degree of risk. The lack of regulation for some of these alternative assets means that there may be fewer constraints to prevent potential manipulation or to limit risk from highly concentrated positions in a single investment. Finally, hard assets, such as gold bullion, may involve special concerns, such as storage and insurance, while the value of natural resources and commodities can rise and fall as a result of unusual weather or natural disasters.
Have questions? Contact me and we can discuss your financial situation, the alternative assets you’re considering. I can advise you on whether alternative assets have a role in your portfolio, and which types might be appropriate for you.