Alternative Investments Guide
Turn on a business news channel or look at the homepage of a finance publication, and there’s a good chance you’ll see commentary on the stock market. And if not stocks, they’re probably discussing what’s happening in the bond market.
But there’s much more to the investment world than publicly traded, traditional assets.
Other types of assets known as alternative investments also exist. These assets can be more complex and aren’t always as straightforward as traditional investments, but they can provide diversification and the potential for outsized returns in some cases.
What Are Alternative Investments?
Alternative investments are assets that fall outside of the mainstream investment world. Definitions can vary slightly, but typically that means anything that’s not a publicly traded stock, bond, or cash.
Alternative investments are sometimes considered an asset class as a whole — e.g., an investment strategy could include having an alts bucket to complement your traditional investment portfolio of stocks and bonds. Other times, investors consider different types of alternative investments to be their own asset classes, such as:
Hedge funds: While these funds often trade public stocks, they’re considered alternative investments because of the freedom these funds have to engage in practices like short selling (i.e., betting that stocks will fall) as well as investing in private markets and other asset classes. These funds are generally only open to accredited investors and have high investment minimums.
Private equity: As opposed to publicly traded stocks, private equity, like shares of startups, is another type of alternative investment. Private equity is the broader category that includes areas like venture capital. Basically, any ownership stake in a privately held company is considered to be private equity.
Accredited investors can bypass private equity funds and VC funds, which aren’t always accessible to individuals, and buy pre-IPO stock through a secondary marketplace like Forge.
Private debt: This alternative asset class is similar to private equity but involves buying debt or loaning money privately, rather than buying equity stakes. However, this differs from buying public bonds, which are generally traded on open markets.
Private debt “loans are usually highly negotiated and transacted directly between a borrower and a non-bank direct lender and are not publicly traded,” explains CalPERS.
While institutional investors might work out their own deals, individuals might be able to access this asset class, too, via online lending marketplaces.
Real assets: This category of alternative investments can include areas like real estate and infrastructure. The structure of these investments can differ, such as with some institutional investors allocating to a real estate fund, whereas an individual might buy an investment property directly, for example.
Commodities: This broad category includes assets like gold, coffee, and crude oil. Basically, when you’re trading a type of good that’s interchangeable with others in the same category (an ounce of gold held in one vault is generally the same as an ounce of gold held elsewhere), that’s a commodity. In contrast, an acre of land in one state isn’t necessarily equal to an acre of land in another.
While commodity markets can be public and are relatively accessible to all, commodities are generally considered to be alternative investments, as they generally have a low correlation with traditional investments like stocks.
Collectibles: Unlike commodities, collectibles are goods valued for their uniqueness. Some investors put money into alternative investments like rare wine, jewelry, or other types of collectible items.
These markets often lack the liquidity of traditional investments like stocks, and they can be volatile as trends come and go, but some investors benefit from selling collectibles at the right time.
Derivatives: This broad category includes assets derived from other assets, like credit default swaps. With credit default swaps, the buyer essentially purchases protection in case of default for the underlying credit obligation.
Derivatives can be complex, but they can offer investors unique ways to manage risk or gain exposure to certain markets that might otherwise be difficult, for example. Some investors, like institutions, allocate directly to derivatives, while others, like some individuals, might gain exposure via a publicly traded fund, though much depends on the derivatives in question.
How Do Alternative Investments Differ From Traditional Investments?
The difference between alternative investments and traditional investments isn’t just the split in terms of the aforementioned asset classes — with traditional investments generally encompassing public stocks, fixed income and cash. They also differ in areas like objectives, and complexity, and risk.
The goal of allocating to alternative investments is often to provide uncorrelated returns to traditional investments and/or to increase return potential.
So, if the public stock market falls, for example, maybe certain alternative funds like hedge funds rise, due to short selling public stocks. Or, maybe some private equity investments hold up better than public stocks during rocky periods, such as if the private investments aren’t subject to the same quarterly earnings scrutiny that could drag down stocks.
And if all goes well, alternatives can sometimes provide outsized returns. However, alternative investments are often more complex and carry more risk than traditional investments, though it depends on the situation.
For example, alts often lack the liquidity of traditional investments, so if you need to sell, you might have trouble finding a buyer quickly and at a fair price. Alternative investments can also come with higher fees than traditional investments.
For these reasons, many investors make alternative investments a smaller slice of an overall investment portfolio.