Expert investors know the value of diversifying their portfolio. In an ever-evolving market, it’s critical to spread risk across a variety of different investment types, so that if one takes a hit, the others can offset the loss.
For example, those trying to prepare for a recession would want to combat a volatile stock market by balancing their portfolio out with a mix of investments, such as bonds, equity funds, and cash. To effectively maximize the value of your portfolio, though, it’s crucial to understand alternative investments.
Below is a definition of what alternative investments are, how they differ from traditional investments, and examples of alternative investments.
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An alternative investment is a financial asset that’s not stocks, bonds, or cash. These types of investments are typically illiquid—meaning they can’t be easily sold or converted into cash—and are often unregulated by the U.S. Securities and Exchange Commission (SEC) or other regulatory bodies. Alternative investments are also sometimes called alternative assets.
Alternative investments used to be limited to high-net-worth and institutional investors, but are becoming more mainstream. Retail, or individual, investors are increasingly getting the opportunity to incorporate these types of assets into their portfolios to reduce overall risk and maximize value over the longer term.
It’s become one of the fast-growing fields in finance: The alternative investment industry is expected to grow 59 percent by 2023, reaching $14 trillion in assets under management, according to research firm Preqin. One reason for the steady rise is that investors are looking for more asset classes with lower correlations—a measurement of how two securities move in relation to each other. The lower the correlation, the less likely the two will react the same way during an economic downturn or upswing.
The Difference Between Alternative and Traditional Investments
Traditional investments are investments that can be bought, sold, and traded on a public market. Stocks, bonds, and cash, or cash equivalents, are considered to be traditional investments. Because traditional investments are publicly traded, they can be converted into cash fairly easily and are considered highly liquid. They're also regulated by various regulatory bodies, such as the SEC, Federal Reserve Board (FRB), Federal Deposit Insurance Corporation (FDIC), and Financial Conduct Authority (FCA).
Alternative investments, on the other hand, are not publicly traded. This makes them less liquid than traditional investments and harder to convert into cash quickly. They can be exceptionally complex and typically not heavily regulated. Because they’re not heavily regulated, there’s often less transparency around these types of investments, making it incredibly important for investors to perform due diligence in evaluating an investment.
Alternative investments are considered riskier than traditional investments yet carry a greater opportunity for reward. Due to their illiquidity, alternative investments typically have longer investment timelines than traditional investments.
Types of Alternative Investments
Because the term “alternative investments” is so broad, many investments can fall under its umbrella. Some of the most common types of alternative investments include:
- Private equity: Equity in a privately held company
- Private debt: Debt investments not held by a bank or traded on the open market
- Hedge funds: Investment funds that primarily trade illiquid assets
- Real estate: Including land, buildings, and other structures
- Commodities: Real, physical assets, such as agricultural products, oil, and precious metals
- Collectibles: A range of physical items, such as artwork, cars, and wine
- Structured products: Alternative assets that involve fixed income
- Venture capital: Investments made in privately held startups
- Distressed debt: Debt purchased from a failing company, with the hope of that company turning around
- Derivatives: Financial assets that are derived from another asset
- Intellectual property: Intangible assets that can include anything from patents to creative works, such as film or music catalogs
Examples of Alternative Investments
The list of alternative investments is long, but here are four of the most popular examples from above that an investor might want to consider adding to their portfolio.
1. Private Equity
Private equity is equity, or ownership, not listed on a public exchange. Private equity firms raise funds from non-institutional and institutional investors and use that money to buy a business with the goal of later selling it to make a profit.
Depending on what stage the company is in, private equity investments can take on different forms, such as:
- Venture capital: Funding used to help promising startup and early-stage ventures gain traction and achieve long-term success
- Growth capital: An investment that enables mature companies to build out new product lines, expand to different geographies, or restructure the organization
- Buyouts: Capital used to purchase another company or one of its divisions
Related: Financial Terminology: 20 Financial Terms to Know
2. Private Debt
When a company is looking to grow its business, it may not have the money or assets to expand. Instead, it might take on private debt, or receive a loan from a private debt fund, as an alternative to bank lending.
Firms that offer private debt typically make money off interest payments from the loan provided, as well as from the repayment of the loan itself. Private debt is illiquid and cannot be traded, yet can balance out a firm’s fixed-income investments.
3. Hedge Funds
A hedge fund is a pooled investment structure that uses different strategies to earn alpha, or an active return on investment. Hedge funds are exclusively for high-net-worth individuals and institutional investors and operate with much less regulatory oversight by the SEC. Most hedge funds invest in traditional securities, such as stocks, bonds, and commodities.
A common hedge fund strategy is long/short equity, in which investors will take a long position, or buy, a stock they think will rise in value and take a short position, or sell, a stock expected to decline. The goal is to minimize the amount an investor can lose, while profiting from gains from the long position and price declines from the short position.
4. Real Estate
Real estate is the world’s biggest asset class, and is typically known as an alternative when individuals buy property such as office buildings or residential apartments as an investment.
Real estate shares similar characteristics with bonds, in that landlords earn current cash flow from tenants, and equity, in that their goal is to increase the value of their property over time. Yet, an added benefit of real estate is that the market is less volatile than stocks and bonds.
Investors who don’t want to be landlords might put their money into a real estate investment trust (REIT). A REIT manager will invest their money in different properties, and then manage and collect rent on those properties. Investors will earn annual profits in the form of dividends, or a share in the properties’ profits.
Why Alternative Investments?
There are several reasons why you should leverage alternative investments.
First, alternative assets have a low correlation with traditional investments like those traded on the stock market. Because of this low correlation, alternative investments often perform better than traditional investments during a market downturn. This means that incorporating alternative investments into a portfolio can be an effective means of increasing diversification and reducing risk.
While alternatives are more complex and often have high risk profiles, they can also generate higher returns than traditional investment types—reportedly sometimes in the range of 50 to 100 percent. To account for this increased potential for risk, alternative investments will typically have a longer investment horizon than more traditional investments.
Lastly, there’s a wider range of alternative investment opportunities, such as those listed above, providing you with more diverse options than the traditional stocks, bonds, and cash.
Diversifying Your Portfolio with Alternative Investments
Now's the time to start exploring the alternative investments industry. By knowing how to speak the language of alternative investments and assess opportunities, you can maximize the value of your portfolio and stand out in one of the fastest-growing fields in finance.
Are you interested in learning more about alternative investments? Explore our five-week online Alternative Investments course and gain the skills, confidence, and strategies to assess potential investment opportunities. Do you want to build your financial fluency? Download our free Financial Terms Cheat Sheet.
This post was updated on July 8, 2021. It was originally published on April 28, 2020.
