Exploring Alternative InvestmentsSubmitted by MIRUS Financial Partners on March 22nd, 2021
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. So-called 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 highly flexible; it can refer to almost anything of whose 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, investing in geographic regions, such as emerging global markets, are considered alternative assets. Complex or novel investing methods also qualify. For example, hedge funds use techniques that are off limits for most mutual funds, while private equity investments rely on skill in selecting and managing specific businesses. Finally, collectibles are included because the value of your 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, you would do well to seek expert guidance if you want to include alternative assets in a portfolio.
Hedge funds are private investment vehicles that manage money for institutions and wealthy individuals. They typically are 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 were named because of their ability to hedge against a market downturn by selling short. Though they may include stocks and bonds, hedge funds are considered an alternative asset class because of the 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).
Private Equity or Venture Capital
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.
Private equity often requires a long-term focus. Investments may take years to produce any meaningful cash flow (if indeed they ever do); many funds have ten-year time horizons. Like hedge funds, private equity also typically requires a large investment and is available only to investors who meet high SEC net worth and income requirements.
Art, Antiques, Gems, and Collectibles
Some investors are drawn to these 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.
Investors have traditionally purchased precious metals because they believe 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 may help hedge against inflation and currency fluctuations. As a result, gold prices often rise when investors are worried that the dollar is losing value, though prices 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
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 with timber, the resource replenishes itself; in other cases, such as with 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.
Investing in Real Estate
You may make either 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 publicly traded. 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.
Commodities and Financial Futures
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. In addition, 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.
Why Invest in Alternative Asset Classes?
Part of sound portfolio management is diversifying investments so that if one type of investment is performing poorly, the investor can still benefit if another is 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 the 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, though diversification cannot guarantee a profit or ensure against a loss.
Understand the Tradeoffs
Alternative assets can be less liquid than stocks or bonds. Depending on the investment, there may be restrictions on when you can sell, and you may or may not be able to find a buyer. Performance, values, and risks may be more difficult to research and assess accurately. Also, you may not be eligible 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. Because some are subject to less regulation than other investments, 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 natural resources and commodities can suffer from unusual weather or natural disasters.
A financial professional can advise you on whether alternative assets may have a profitable role in your portfolio and which types might be appropriate for you.
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.
Want to learn more about different ways to invest? Check out these articles from Mirus Financial Partners.