January 20, 2020

How Might Alternative Investments Fit Into Your Portfolio?

To understand the concept behind alternative investments, you don’t have to think far beyond your own kitchen. There are certain staple foods you cook on a daily basis, things you would consider “conventional.” The ingredients are easy to find and affordable. The knowledge and time to cook the dishes are well within expectations.

Every now and then, however, you diversify your culinary mix by cooking something a bit more exotic–an epicurean “alternative” to your more “conventional” meals at home. The ingredients or spices may not be as easy to find, and perhaps they may even cost a bit more. The time and skill to cook the dishes may be more involved as the entire process is likely unfamiliar, beyond your comfort zone.

When it comes to investments, the principle is very similar to the analogy above.

Defining Alternative Investments

Alternative investments are financial assets that don’t fall into “conventional” categories. Most investors are familiar with assets of the conventional type–stocks, bonds, index funds, and cash (or cash-based instruments)–as they’re the mainstream financial products covered by the media and offered by most financial institutions. In contrast, many alternative investments, particularly privately-transacted assets, are rarely mentioned and almost never offered.

On the other hand, alternative assets come in different forms including (but not limited to) commodities, managed futures, hedge funds, venture capital, real estate, cryptocurrencies, fine art, antiques, wine, and plenty more. Before we dive into the more “common” forms of alternative investments, let’s look at the common characteristics that many of them share. In other words, what characterizes alternative investments as a class of assets that differ from conventional investment vehicles?

Characteristics of Alternative Investments

Note that the following characteristics don’t apply equally across the board. They vary according to the structure of each instrument. For instance, the S&P 500 emini futures may seem as liquid as a highly-traded stock on the NYSE, but this characteristic isn’t necessarily shared by other commodity futures, such as lumber or rough rice futures–both of which can be highly illiquid at times. Yet the lumber and rough rice markets are comparatively more liquid than those for real estate, antique collectibles, or fine art.

So approach the following characteristics with a mind toward variability.

Most are illiquid: Many alternative investments, particularly those that aren’t traded on an open market, have fewer buyers and sellers, meaning they can vary from being moderately to highly illiquid. Less liquidity can mean more inefficiency in pricing. It can also take a longer time to make a purchase or sale, which greatly affects their fungibility (convertibility to cash or something equivalent in  value).

Varying degrees of complexity: Some investors may find certain alternative investments to be quite complex. On one hand, this may be due to unfamiliarity. On the other hand, some alternative investments, such as venture capital, private debt, or real estate can be inherently complex–involving many moving parts and institutional parties. For this reason, alternative investments are often the domain of institutional or high-net-worth investors, as they typically have the expertise and capital to engage in such complex transactions.

High fee structures: Depending on the nature of the asset and the number of institutions involved in the transaction, alternative investments can have a higher minimum investment requirement and a more complex fee structure than most conventional investments (e.g. stocks, bonds, and index funds). A real estate investment purchase, for example, illustrates the characteristics of high minimum cost and/or high fee structure.

Less regulatory oversight:  Some alternative assets, particularly ones that are publicly traded on an open market, are highly regulated (e.g. futures). But many that are privately or just infrequently traded are not highly regulated. For instance, sales of collectible antiques or wine may not be regulated by a financial governing authority. And although certain cryptocurrencies have made headway in terms of liquidity via online exchanges, financial regulatory oversight is nowhere near that of the securities or commodity futures industry.

Riskier than conventional assets: Because many alternative investments tend to be illiquid, less fungible, more complex, expensive, less regulated, or in some cases highly-leveraged, they tend to be riskier than most conventional investments. Because of their risk profiles, alternative investments are best handled directly by experienced and well-capitalized investors. Otherwise, seeking the services of an investment professional who specializes in alternative investments may be a wise solution.

Now that you understand the general characteristics that tend to dissuade most conventional investors, what’s the big appeal over alternative investments?

The Potential Value of Alternative Investments

The simple answer is diversification–as either an additional return source, or an asset whose returns are not affected by the same economic factors as conventional investments (namely, the stock and bond market).

If your portfolio of stocks are sinking, it helps to hold assets that are either not declining along with your stocks, or rising on their own fundamental merit. Perhaps this sounds like a good idea, as in something that’s easier said than done. But what kind of alternative investments might you consider, and how might it fit into your portfolio? Here are a few alternative investments you might want to be aware of:

Five Alternative Investments You Might Want to Consider

  • Commodity futures: There are various commodities that have little to no correlation to the broader stock market. You might want to consider investing in a diversified basket of non-correlated commodities either directly or through a managed futures fund.
  • Real assets: There is a wide mix of assets that may fall under the “real assets” category. Beyond the more standard physical commodities, you have assets like farmland, jewelry, wine, antiques, numismatic coins, fine art, and plenty more. All follow a different set of fundamentals. Bear in mind that you should probably know something about the markets that might interest you as an investor. But if you are interested in apportioning a part of your total portfolio to any of these asset classes, they do present a means for exotic diversification.
  • Private equity: It’s almost like investing in stocks, but this broad category deals directly with “private” (and not public) companies. Think of it as venture capital, one in which you can invest directly into private businesses from startups to more mature companies.
  • Private placement debt: Similar to bonds, private companies issue private placement debt to help finance their operations. Because private debt doesn’t require credit agency ratings, it helps to fully understand the finances of a company whose debt issuances you are taking on as a lender. Sometimes, a company may issue promissory notes that are not backed by anything other than its ability to repay debt. In other instances, you may have a claim on a portion of the company’s assets, a type of arrangement known as mezzanine debt. If you are able to secure a favorable private debt investment, it may serve as a valuable income stream, particularly if the company you are lending money to does well.
  • Hedge funds and fund of funds: Perhaps one of the more popular forms of alternative investments come via hedge funds and fund of funds. Similar to mutual funds, both types of funds are handled by a professional money manager. The similarities, however, end there. 

A hedge fund is a managed fund that has the capacity to implement strategies exceeding those offered by the typical mutual fund. A hedge fund may go “long” or “short” various markets, deploy complex strategies (e.g. various arbitrage approaches), invest in distressed assets and other less-conventional investments. Hedge funds typically invest in publicly-traded assets, unlike private equity, so investors may find it easier to get their money into and out of hedge funds.

A fund of funds is like a megafund that invests in multiple funds, money managers, and strategies. Perhaps the greatest value this fund type offers is that of “strategy diversification.” Instead of investing in a “basket of assets,” an investor is investing in a “basket of strategies and money managers” in addition to holding a diversified mix of assets.

The Bottom Line

Alternative investments can offer various opportunities in multiplying and diversifying your return source. But it’s not for everyone. So before adding exotic ingredients to your main dish, be sure you enjoy the flavors and can tolerate the spices that some investors may find harsh.

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