6 Types Of Alternative Investments Every Investor Should Know
With low interest rates and volatility in traditional stock and bond markets, some investors are seeking alternative investments to increase their portfolio diversification in the hopes of enhancing returns. What is an alternative investment, and what are some of the more common types of alternative investments? Here are 6 types of alternative investments every investor and financial professional should understand.
What Is An Alternative Investment?
An alternative investment is a financial asset that does not fall under one of the traditional investment classes (i.e. stocks, bonds, and cash). As alternative investments become progressively more accessible to retail investors, understanding them becomes increasingly important for investors and financial professionals alike.
6 Common Types Of Alternative Investments
1. Private Equity
Private equity investing refers to taking an ownership stake in companies that are not listed on a public stock exchange, such as the Toronto Stock Exchange (TSX). Subsets of private equity include venture capital, growth capital and buyouts. The goal is to provide capital to help a new business grow or to increase the operational efficiency of an existing business with the potential to produce significant long-term gains in return, which could involve the company being taken public.
2. Private Debt
Investing in private debt refers to purchasing investment vehicles that are neither offered by banks, nor traded on an open market. The “private” part of the term “private debt” refers to the investment vehicle and not the type of company issuing the debt—both public and private companies can borrow through private debt.
3. Hedge Funds
Hedge funds are actively managed investment funds that use a range of non-traditional investment strategies with the goal of earning a high overall return. Such strategies can include long-short equity strategy (taking long positions in stocks that are expected to appreciate and short positions in stocks that are expected to decline), or investing in more complex asset classes. Notably, hedge funds commonly use leverage, invest in derivatives such as options and futures, and are free to choose esoteric investments that more traditional investors do not usually touch.
4. Real Estate
Real estate is the most common type of “real” asset investing. Real estate investing has similar characteristics to those of bonds—property owners receive cash flow from tenants paying rent as well as potential capital appreciation of the actual property. You can also invest in real estate without purchasing the physical property by investing in Real Estate Investment Trusts (REITs).
Commodities are also “real” assets, mainly natural resources such as precious metals, oil, and natural gas. The values of such alternative investment assets generally correlate highly with supply and demand dynamics.
Lastly, for some collectors, collectibles are investments like other “real” assets. Investing in collectibles refers to purchasing and maintaining tangible items ranging from rare wine to fine art, in hopes that the values of the collectibles will rise over time. Risks include high acquisition costs, lack of cash flows until the item is sold, and potential loss or deterioration of the assets.
The Bottom Line
While alternative investments open the door to greater portfolio diversification and opportunities to boost returns, they typically have a few important shortfalls in common:
- Depending on the form of the alternative investment, it can be fairly illiquid compared to its traditional counterparts, mainly due to a smaller number of market participants.
- It is often difficult to value and measure the performance of an alternative investment—some alternative investments are so unique that it is nearly impossible to find references for valuation, hence they are subject to various biases such as “expert opinion” or theoretical valuation models.
- Alternative investments are complex and inherently risky with the possibility of investments being written off completely— “going to zero.”
Investors and financial professionals alike must make well informed decisions regarding the role of alternative investments in their or their client’s investment portfolios. To do this it is imperative that they perform thorough due diligence on an offering, including its sponsor, manager, and all parties involved, before committing to an alternative investment.
If alternative investments are not for you or your clients, or if you only want to allocate a small percentage of your or your client’s assets to alternative investments, you may wish to work with a traditional investment manager whose investment methodology is deeply rooted in preserving and building wealth for the future and who can also help guide you and work with a specialist in the particular alternative space of interest.
This content is provided for general informational purposes only and does not constitute financial, investment, tax, legal or accounting advice nor does it constitute an offer or solicitation to buy or sell any securities referred to. Individual circumstances and current events are critical to sound investment planning; anyone wishing to act on this content should consult with his or her financial partner or advisor.