What are alternative investments?

An alternative investment is any investment type outside of the traditional categories. Stocks, bonds, and cash are considered traditional investment categories. Alternative investments include real estate, private equity or venture capital, start-up companies, art and antiques, films, and commodities, to name a few.

Historically, only institutional investors and accredited investors could access alternative investments for reasons we’ll discuss below. But in recent times, regular retail investors have gotten access via alt funds, ETFs, and mutual funds.

Financial advisors agree that diversifying your portfolio is a fundamental investment strategy, and expanding into alternative investments is one way to do so. By investing in assets with low correlations and are likely to perform differently in various market conditions, you’re more likely to maximize your overall returns and minimize your risks. 

Although diversification doesn’t guarantee against loss, it is an important tool for lowering your risk. In fact, alternative investments often move counter to the stock and bond markets. Hard assets like precious metals, oil, and real estate can hedge against inflation. 

In addition, large institutional funds, like pension funds, often allocate a small portion of their portfolios to alternative investments, like hedge funds. These funds have historically provided some protection in down markets. When the stock market experiences big corrections, hedge funds have buffered the fall. They’re generally considered a good way to supplement a portfolio and buffer risk but not substitute for traditional investment.

There are advantages and disadvantages of investing in these kinds of asset classes, and how to invest in them differs from traditional investments. 

Advantages of alternative investments:

• Less fluctuation. Alternative investments typically don’t relate to standard asset classes; in other words, they don’t generally fluctuate with the stock market, so they’re usually not affected by market conditions. They’re often considered a good way to diversify your portfolio.

• Diversify your portfolio. Since alternative investments have a low correlation to the stock market, they can help diversify your portfolio. By investing in alt funds or liquid alts, you’ll have access to markets you wouldn’t have had access to before, such as early investment in a start-up.

• High rewards. Alternative investments can appeal to investors who have a particular specialty (like coin or art collecting) and are willing to take informed risks with the potential for a high reward. 

• Hedge against inflation. Since alternative investments usually move counter to traditional assets like stocks and bonds, alt investments can be a good hedge against inflation.

Disadvantages of alternative investments:

• High minimum investments. Most of these assets can only be held by institutional investors or high-net-worth investors that are also accredited. To become accredited, you’d usually have to show a net worth that exceeds $1 million, not including the value of your house, or a personal income of at least $200,000—or $300,000 in joint income. Qualified investors have an investment portfolio of $5 million or more, individually or jointly. 

• More speculative. Most alternative investments don’t have much historical performance data and are difficult to value. Think of collectibles like baseball cards. If you’re not sure how many exist in the world or how many are hiding in attics, it can be hard to determine their true market value.

• Fairly illiquid. Most of these investments are illiquid compared to conventional investments. Those baseball cards will only appeal to a niche market, so they might be hard to sell—much harder to sell than stocks, for example. Real estate can also be hard—or at least time consuming—to sell. 

• Less regulation. Although alternative investments are subject to examination by the SEC, they’re not usually required to register with the SEC. In other words, they don’t have the same kind of regulation as, say, mutual funds, which makes them a riskier investment. For this reason, they can also be more likely to expose investors to investment scams or fraud. 

• Fee structures. Fees can be high, with upfront fees on alternative investment funds at 2% annually, and managers taking 20% of the gains. 

It’s important to note that non-accredited retail investors can still access alt investments via alternative mutual funds and exchange-traded funds (also called “alt funds” and “liquid alternatives”).

When investing in alternative assets, people usually have motivations beyond wealth-building and diversification. They do it for the passion of collecting, to contribute to an industry (like film or art) they care about, or for the excitement of getting in on the ground level of a new company. Here are some types of alternative investments to look for:

Real estate

When people buy investment property such as office or multifamily buildings, that’s considered an alternative investment. Those who don’t want to get quite so up-close and personal with their investment might use a broker to buy into private real estate investment trusts, or REITs. Publicly traded REITs are listed on stock exchanges. 

Other private real estate investments include timberland (investing in forest growth) and farmland. Real estate is considered an inflation hedge, making it a choice for diversification, and there are tax benefits in renting out investment property.

Commodities

Natural resource investments, such as oil, corn, rice, and coffee are real assets, and considered an inflation hedge. But investors should be aware that commodity trades happen in the futures market, with set times during the year when contracts mature. Investors sell the contract before it matures and buy a new one to hold the position. 

Art and collectibles

This alt investment requires plenty of industry knowledge—or a willingness to hold on to the investment for many years. It’s difficult to judge how a work of art or a collectible will appreciate, and artwork and collectibles can lose value or get damaged. Those who invest in this asset class should do it for the love of the work—not the expectation of quick gains.

Private equity

The purpose of private equity is to invest capital into private companies and help them restructure. It generally makes the most sense for high-net-worth investors because it means acquiring a company, but investors often form a group to make the purchase. Your money can be tied up for years until the fund sells the holdings in an IPO or to a strategic buyer. Venture capital falls under the private equity umbrella and involves investing in early-stage companies or start-ups looking to expand rapidly.

Start-up companies

Bypassing a private equity fund and investing directly into start-ups is sometimes called angel investing. Considering the high failure rate for start-up companies, investing in start-ups is regarded as high risk/high return.

These are just some of the forms of alternative investments. As in every investment, it’s important to do your due diligence. What kind of ROI can you predict on an apartment building, based on the market rent you could charge for every unit? What can you find out about a fund’s historical performance? Is the art you’re buying simply an investment or a passion purchase you’d be happy to hold on to? How risk-averse are you? How diverse is your investment portfolio? These are all questions you’ll want to answer.

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