What is an Alternative Investment?

Our aim is to be the authority on all forms of alternative investments.

What is an alternative investment?

1427922667_bank_building_government_structure_banking_office_classic_courthouse_financial_institution_flat_design_icon-512This is quite an expansive question and can incorporate a really wide range of asset types. In essence, an alternative investment is any investment that is not one of the three traditional asset types (stocks, bonds and cash).

The world of alternative investments is a murky one. Whilst the potential rewards are often high, most areas are completely unregulated and highly illiquid, as such the risks can be quite high.

As with any investment type, there are legitimate opportunities but there are also scams. See our guide to common investment scams and how to avoid them.

Our aim is to guide you through the various alternative investment types out there so you can make an informed choice. We do not offer advice, merely information and you are advised to seek professional counsel before committing any funds.

If you trade in stocks, bonds or cash investments, these are regarded as the three traditional asset types.

Most of us with money to invest will predominantly have trusted our money to a combination of these three investment opportunities, but when your wealth increases and you decide to seek more diverse openings and prospects for growing your money, you will probably want to explore the world of alternative investments.

The basic definition of an alternative investment is an asset that is more complex in nature than simply owning stocks and shares that you can buy and sell based on their current price.

High net-worth individuals and more adventurous investors like the idea of greater diversity in their investment strategy and as a feature of many alternative investments is limited financial regulation and a potential lack of liquidity, the increased risk-reward environment is attractive.

We will look at the various alternative investment opportunities in greater detail and you can find a section on this website that deals with each one, so that you can learn about any specific type of investment that particularly appeals to you.

To get a flavor of what an alternative investment is, we are talking about real estate investments, commodities and derivatives contracts and hedge funds, amongst others.

Many alternative investments tend to have a reasonably high minimum investment requirement and the fee structures quoted by the provider will often be at a higher level than you would expect to pay if your money was invested in a mutual fund or an ETF.

It should be remembered that whilst the fact that many of these alternative investments are subject to much less regulation in comparison to traditional asset-based investments, the downside to that is the lack of verifiable performance data available in which to attract potential investors in the usual way with examples of how well they have done in the past (without of course, being able to guarantee what is going to happen to your money in the future)

A fair number of the large institutional funds such as pension providers have started to allocate a relatively small proportion of their portfolio to alternative investments such as hedge funds. Their thinking behind this is that alternative investments can be viewed favorably as their returns are not underpinned by those of standard asset classes. The higher risk and reward scenario is understandably attractive to these large funds as they seek out opportunities to diverse, but they tend to limit their total exposure to alternative investments to a figure somewhere below 10% of their total portfolio.

If you are looking at different ways of getting your money to work harder for you, alternative investments are well worth considering if they are a good fit to your financial position and risk profile.

What are the risks of alternative investments?

When you consider that there are an estimated 10,000+ alternative investment opportunities available in the form of hedge funds, private equity funds and real estate and infrastructure funds, there are going to be risks attached and some performance volatility to contend with.

Fee structures with many alternative investments work on what is often referred to as a 2 and 20 fee structure. This means that you will be charged a 2% annual management fee and a commission rate of 20% if the fund exceeds a certain return threshold. The risk is that high fees can eat into your capital invested if the fund performs badly or not well enough to justify the commission rate that will be sliced off the value when it is due.

As some alternative investments are more complex in nature and fund managers invest in a variety of investments such as derivatives and also utilize short selling strategies, this can make due diligence more challenging.

Other risks to consider include the potential lack of liquidity in some investments, which means you may not be able to get all of your money out when you want to. There is also a lower level of transparency with some funds to be aware of, which means you can’t compare funds as easily as you can with more traditional investments.

What are the rewards?

The principal reason why investors are tempted to consider putting their money into alternative investments, is the prospect of higher returns.

There is definitely the potential for alternative investments to outperform traditional investment vehicles and another positive benefit is the fact that you are diversifying exposure away from traditional fixed income and equity assets for part of your portfolio.

Higher risks can lead to higher rewards and alternative investments can offer investors the path to making the most of their money and the diverse opportunities that exist.

The “alternative investing” sector is growing rapidly, so much so that at least two large organizations have come into existence to cater to the needs of consumers who want information about this kind of investing.

In common parlance, when laypeople speak of alternative choices for investors, they are referring to anything other than stocks, bonds, mutual funds and similar securities. Even then, there is some crossover as many consider investing in gold mutual funds for example to be an alternative investment or putting cash into mini-bonds via a crowdfunding platform.

Because there is, as yet, no legal definition of “alternative investing,” the term is rather fluid. However, most accountants and brokers use the moniker when referring to precious metals, real estate, hedge funds, tax liens, art, rare coins, and collectible rarities of all kinds.

Organizations

The Alternative Investment Management Association (AIMA) and the Center for Alternative Investments (CAI) are the largest entities that deal with the non-traditional segment of the investment world.

The former is concerned mostly with hedge funds while the CAI is a university-based advisory and research entity based at Emory University in Atlanta, Georgia. The AIMA’s primary mission is to advise hedge fund managers, but the CAI works more at the ground level, helping create networks of alternative investors and educating the public about this new financial trend.

Traditional investments

For consumers who want to put their money in something other than the “stock market” and all its old-school variations, a licensed accountant or investment advisor can usually cover all the bases of securities, bonds, yields, risk and return.

Indeed, the bulk of all consumer investment money is in the traditional market. There is never a shortage of stock brokers or accountants in any large city.

Both are professionals who are closely regulated by nationalgovernments and typically must meet regular testing and educational requirements to stay in business.

The global stock and bond market has good and bad years. So far, no one has come up with a reliable method of predicting yearly returns, though there are some categories, like blue-chip stocks and bonds, which offer moderate returns in good years and moderate losses in bad ones. Abundant academic research has gone into the study of traditional investment profitability, and the general conclusion is that the world’s stock and bond markets are generally a safe place to put at least a part of one’s discretionary investment capital.

Alternative options

Going the alternative route offers the potential for larger profits as well as larger losses. The key difference between traditional and alternative investments is risk. There are exceptions to every rule, and one can find risky stocks as well as rather safe alternative investments.

But for the most part, a typical mutual fund containing a diversified portfolio of blue-chip stocks and bonds carries considerably less risk than a hedge fund made up of small-cap global metals stocks.

Most consumers who turn to the world of alternative investments are able to deal with the higher risks. In addition to that increased risk, hedge funds and other non-traditional investments offer a much wider array of choices, rather than the “stocks, bonds or both?” choice that has been a stalwart of the financial picture for more than a hundred years.

Due diligence is the key to alternative investing

Anyone thinking about delving into alternative investments needs to do some homework. Each sub-sector of the alternative market carries its own risks and rewards, and many of the choices are wildly diverse.

For example, one can choose to invest in hedge funds with portfolios made up of any number of things. Some hedge managers blend their funds with both traditional and non-traditional components. Others seek large returns through riskier, purely alternative choices like precious metals, tax liens, art, coins, high-value assets, real estate and private equity shares.

Investors should keep in mind that many of the larger hedge funds have high minimum investment requirements. For those who want to park less money, many so-called “retail” hedge funds have sprung up to meet their needs.

In either case, one should not only do research independently but should seek the advice of a professional who has experience with alternative investments, and hedge funds in particular.

Precious metals and other choices

The other typical choices for alternative investors, besides hedge funds, include precious metals like gold, silver, platinum and palladium. Metals are attractive to investors who seek long-term gains and who are able to safely store their assets for many years.

Gains and losses in the metals market fluctuate wildly, which means large losses can be incurred or huge gains achieved. Many traditional investors, in fact, use the daily gold price as a benchmark for all sorts of financial analysis studies and decisions.

Some alternative investors avoid funds, stocks, and shares of all kinds.

They are the purists among the crowd, many of whom seek out truly “hard assets” like valuable works of art, diamonds, rare coins and of course precious metals.

This type of investing used to be called “commodity speculation,” which is an apt name for it still.

To take advantage of this sector one needs to be an expert in a niche, or have access to an expert. Buying a painting, for example, takes a keen eye for both art and the potential for future value.

As with the traditional stock and bond market, but to a greater extent, those who want to put money in the alternative investment sector need to do research, consult with professionals and know exactly what they are getting into before making a commitment.

Non-traditional investing can be financially rewarding and exciting. Some consumers are more at home with the old fashioned market, but anyone who can tolerate a bit of risk for at least a portion of their portfolio should consider all the alternatives.