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When it comes to investing, you’re probably familiar with stocks and bonds, but there’s a whole universe of possibilities outside of these traditional asset classes. Alternative assets, from hedge funds and private equity to venture capital and rare collectibles, allow investors to further diversify their holdings and seek returns less correlated to the stock market.
What is an alternative investment?
An alternative investment is a financial asset that falls outside of conventional asset classes, such as stocks, bonds, and cash.
Alternative investments include private equity, venture capital, hedge funds, managed futures, and collectibles like art and antiques. Commodities and real estate can also be classified as alternative investments.
Who can buy alternative investments?
The purchase of many types of alternative assets has historically been limited to financially sophisticated investors such as institutions or high net worth individuals considered accredited investors by the Securities and Exchange Commission (SEC). This is because most alternative investments are not traded on public markets and they are generally not regulated by the SEC.
If you want to buy alternative investments as an accredited investor, you can qualify in several ways: by having an annual income of $200,000 – $300,000 for a couple – in the past two years; maintaining a net worth of $1 million or more; or by demonstrating “defined measures of professional knowledge, experience, or certifications” in the eyes of the SEC.
Types of alternative investments
Hedge funds are pooled private investment funds that seek high returns through varied and often risky investment strategies. They can put participants’ money into just about anything, from publicly traded securities and derivatives to currencies, startups, or a myriad of other assets.
Hedge funds are usually organized into private investment partnerships in which the general partner manages the portfolio and makes the investment decisions. This person’s choices are really limited only by the mandate chosen by the fund.
Private equity funds
Private equity funds are pooled investment vehicles that aim to acquire majority stakes in private and public companies. They take an active role in the management of their portfolio companies, providing intellectual and financial capital.
When a private equity fund acquires a stake in a company, the objective is usually to restructure the company and provide capital to accelerate growth. The fund makes a profit when it liquidates its stake, either by taking a holding company public in an initial public offering (IPO) or by selling it to another company.
Venture capital funds
Venture capital funds provide capital to promising startups in exchange for equity. Like private equity firms, they can play an active role in management and provide the necessary expertise.
However, venture capitalists tend to stay invested longer than private equity funds. They work with the portfolio company and monitor progress, unlocking funding rounds when certain benchmarks are met. They leave the investment following a merger, acquisition or IPO.
Fund of funds
A fund of funds operates much like a hedge fund, but invests in other hedge funds rather than individual stocks, bonds, or other assets. Hedge funds typically have high minimum investment requirements, so this approach can broaden access for investors.
Natural resources include commodities, agricultural land and forests. For large corporations, investing in commodities means buying barrels of oil or trains of iron ore to make other products. Regular investors can invest in commodities through derivatives like futures and options. Investing in forests and farmland provides investors with alternative income streams based on the sale of trees, timber and agricultural commodity prices.
Real estate is the most accessible alternative investment – many Americans are already invested in this asset class by owning their homes. Real estate investment means the purchase of real estate or the purchase of funds that invest in real estate. Real estate investors anticipate appreciation in value over time, while real estate assets such as apartment buildings or shopping malls generate regular rental income.
Advantages of alternative investments
- Low correlation. One of the biggest advantages of alternative investments is their low correlation with traditional asset classes. When the stock market is under pressure, commodities, for example, could do very well.
- Diversification. Thanks to a low correlation with stock or bond markets, including alternatives in a portfolio can improve diversification.
- Less volatility. Since alternative investments are less exposed to the broader market, the impact of market volatility may be less.
- Hedges against inflation. Certain types of alternatives, such as gold, oil or real estate, can be effective in hedging inflation risk. Commodity futures and options can also be used to protect against rising or falling prices.
- Potentially higher returns. Since alternative investments carry a higher level of risk, they also offer the potential for higher returns.
Risks of alternative investments
- Lack of regulation. Not all alternative assets are registered with the SEC and are therefore unregulated. However, they fall under the jurisdiction of the Dodd-Frank Act and therefore their practices may be subject to scrutiny by the SEC.
- Lack of transparency. Since most alternatives are not regulated by the SEC, there are few or no public regulatory filings. This results in a lack of information for investors.
- Low liquidity. Since many alternatives are not publicly traded, it can be difficult to buy or sell these investments. Many hedge funds and private equity funds may have locks that commit investors to a set investment period during which redemptions are not possible.
- Difficult to value. In the absence of a market price, it can be difficult to determine the value of alternative investments. Appraisals can vary widely depending on the appraiser and are more vulnerable to subjectivity.
- High minimum investments. The alternatives are not structured with the average investor in mind, so minimum investment requirements may be excessively high.
- Greater risks. With the potential for high returns comes higher risk. Many alternative investments can involve risky strategies such as short selling or trading complex derivatives.
How to buy alternative investments
Buying alternative investments involves greater challenges than sticking to traditional asset classes. While the potential for higher returns and greater diversification may be alluring, the risk is commensurate. If you are considering alternative investments, you will need to do thorough due diligence and research.
For those who are not qualified investors, access to alternative assets may be limited. However, there are many alternative mutual funds and exchange-traded funds (ETFs) available today, although many come at a premium price.
Take for example the Invesco Global Listed Private Equity (PSP) ETF. This ETF buys stakes in leading private equity funds. With an expense ratio of 1.44%, the fund isn’t cheap, but if you’re not an accredited investor, it’s the price to pay to gain exposure to this type of asset strategy alternatives.
Since these funds are publicly traded instruments, they are registered and regulated by the SEC, which may make them safer choices for non-accredited investors. Sources such as Morningstar can help you identify available funds and ETFs, but the best way to invest in alternatives is to work closely with a financial advisor who can suggest the best options to help you achieve your goals. .