What are Traditional Alternative Investments: How They Can Play a Role in Your Portfolio

February 25, 2022

There is a giant universe of investment options available. However, when people think about investing, our minds often go straight to stocks and bonds. There are entire tv channels devoted to these investment vehicles, not to mention the countless websites, blogs, even memes – and for several good reasons. They are the “simplest” to understand, they’re widely available, and often have the lowest barrier to entry for investors. They are without a doubt, the most common and are top of mind when it comes to personal investing, and you wouldn’t be wrong to think they are some of your only options. Recently, there has been a push in the industry to use alternative investments, so let’s take a closer look at what alternative investments are.

Commonly, anything in the investment universe that isn’t stocks, bonds, mutual funds, or exchange-traded funds (ETF’s) are lumped together as “alternative investments.” This would make you believe that all these products are all alike, but really, it’s a vast group of asset classes that cover a wide range of investments that look, feel, and behave quite differently from each other. Historically, they have only been accessible to higher net worth individuals or those with specific knowledge or skills, but more and more, they have become democratized and are now available to a broader audience. This newfound availability means that we need to have a better understanding of our choices lest we get ourselves in over our heads.

“Traditional” Alts

 There are a group of alternative investments that we have all heard about which means we probably have developed our own unique opinions of them. This group includes your private equity/venture capital funds, hedge funds, real estate, or even commodities. We’ll discuss how each of these differs, but before we do, let’s examine their similarities.

  • They are often unregulated by the Securities and Exchange Commission (SEC)
  • They are illiquid – not easily converted into cash
  • They have low correlation to “standard” asset classes
  • They are better “stores of value” than more traditional investment vehicles

Let’s dive into the more commonly known options of the alternative investment world to understand why we might consider investing in them. We will group a few of these together but understand that they each have their own unique attributes. We combine them because they’re commonly all managed as pools of investor dollars. Rather than buying these personally, we would deposit a sum of money into a fund or business and let others manage it. These “Traditional” Alts are often limited to accredited investors.

Private Equity and Venture Capital

Technically, venture capital is a form of private equity. In each instance, a group of investors makes direct investments in companies. These firms frequently provide more than just capital to companies looking to grow, and often provide expertise, consulting, human capital, and other various intangibles that growing firms might not be able to source on their own.

Private Debt Investments

Firms pool assets together to serve as a lender to companies in need of cash. Often these investment managers target subsections of the economy that are too big for local banks, but not big enough for the megabanks.

Hedge Funds

Hedge funds are interesting because they are technically an alternative investment, but often they’re investing in the same type of things that an average investor is. The key differentiator is the way in which they do it. They may use derivatives or take short positions in companies. They may also leverage their investments to invest more than they have in available assets. Basically, the only limit is their imagination. Hedge funds are often incredibly risky, but they have the potential to provide solid returns.

Next up, we’ll examine the last of our “traditional” alternative investments, real estate, and commodities.

Real Estate

Real estate is a behemoth. It’s the world’s largest asset class and it seems to have a zillion different ways to invest in it. Most of the world “invests” in real estate by buying a home to live in. Some people buy renthouses or flip properties as an investment. Some people pool their money and buy large amounts of income-generating properties. There are so many ways to invest in real estate that we could spend hours on just this topic alone. There are some key things to know about it, though:

  • Real estate is super illiquid. Most alternative investments are, but the sales cycle on homes is unpredictable and can be quite long.
  • It’s a lot like bonds. Real estate investment is almost all about the interim cash flow with hopes that the value will increase over time.

Commodities

Commodities, like many alternative investment categories, can be a large sector all to itself. Everybody probably has a different thought of what a commodity is – oil and natural gas is top of mind in Oklahoma – but the reality is that it is so much bigger. Any natural resource can count as a commodity. Wheat, oil and gas, metals like gold, silver, tungsten, or lithium.

The way we invest in commodities is almost as diverse as the sector itself – we can invest directly in the commodity. All it takes is finding a gold or jewelry store near you and buying whatever natural resource you’re looking for. Some are simple, but it’s not always as easy as walking down the street to buy some gold. And for other types of commodities, not everyone has storage units for cattle or oil, so they must find other ways to invest.

The most common way we see people investing in commodities is through futures contracts. In simple terms, a futures contract is an agreement to buy a specific amount of a good at a set date and price. Futures contracts trade on specific markets and the prices of each contract rise and fall depending upon the perceived demand for the underlying good. An investor makes money if they can sell their contract to someone else at a higher price than they bought it. Investing in funds that manage portfolios of various commodities has a low barrier to entry as you don’t have to have tons of knowledge about the underlying securities. By working with an experienced asset manager, you are effectively investing in a pooled fund (like a mutual fund or private equity fund) and letting someone invest to their best ability.

Commodities can be extremely volatile. They are prone to wild speculation and natural factors like weather, disease, and more. Remember back in 2020 when oil traded at negative prices? Some commodities (like gold or other precious metals/gemstones) have held their value, but others represent an investment that has huge risk and reward potential. Just like any alternative investment, you would buy them to have returns that don’t track along with stock markets, but you must be very aware of your personal risk tolerance before diving into commodity investing.

As you can see, there are many ways to invest outside of your everyday stocks and bonds (although we haven’t even discussed Alternative Alts yet. Keep an eye out for our next blog on this topic). With any investment, you will want to examine your own risk tolerance and overall financial plan and goals.  A financial advisor can be a great partner to help you decide on a plan and assist you in navigating some of the alternative investment options at your disposal.

 

Commodities generally are volatile and are not suitable for all investors. Mutual funds or ETFs focusing on a single sector generally experience greater volatility. Investment products in the commodity asset class often employ leverage which can work against investors as well as for investors. The use of leverage can lead to large losses as well as gains. Investment products in the commodity space may invest in commodity-linked derivatives which may be subject to special risks such as counterparty risk. A counterparty with whom an investment does business may decline in financial health and may be unable to honor its commitments, which could cause losses for the investment.

Changes in real estate values or economic downturns can have a significant negative effect on issuers in the real estate industry.

 

Sources

https://online.hbs.edu/blog/post/types-of-alternative-investments

https://www.fool.com/investing/how-to-invest/hedge-fund/

https://www.uschamber.com/co/run/business-financing/private-equity-vs-venture-capital

https://www.fool.com/investing/how-to-invest/stocks/commodity-trading/

 

 

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