The alternative world
Investing has gone from the days of late as a fee-loaded, cumbersome ordeal to becoming democratized in the present, with access to instantaneous trades on fee-free platforms. However, the new trend of introducing alternative investments is proliferating in the advisor-managed portfolio space. What are they, and are they worthwhile?
What are alternative investments?
Alternatives are an asset class outside the typical stocks and bonds used in portfolio construction. For a refresher on stocks and bonds, I recommend reading Discover Stocks And Bonds; Not Your Grandma’s Guide.
A defining attribute of alternative investments is that many have high transaction fees, auxiliary costs, complexity, illiquidity (i.e., limited trading ability), limited transparency, and high initial investment minimums. These characteristics make most alternatives unsuitable and unobtainable for most investors, which led to the Securities and Exchange Commission (SEC) instituting income and net worth limits on particular investments to protect the average individual. Still, interest remains in them due to their potentially uncorrelated performance with the broader market and the potential for increased returns.
Various types of alternative investments
Examples of alternative investments include gold and other precious metals, cryptocurrencies, commodities, particular REITs and real estate investments, private equity and credit, hedge funds, derivatives, antiques, and art. I have included brief descriptions for each of these examples below.
Gold and other precious metals include gold, silver, platinum, palladium, and rhodium. Some of these metals, such as gold and silver, have been used as a store of value for eons. Investing in gold is simple and is done by buying physical bullion or an ETF, making it highly liquid and not money intensive. However, I firmly believe gold is only a store of value over extended periods, not an investment. I authored an article titled Should Gold Be In Your Portfolio: 3 Things To Know, where I outlined my position.
Cryptocurrency is a digital asset class stored on the blockchain, which is, in essence, a public ledger that verifies ownership. It is easily purchased on various exchanges and through financial institutions. Liquidity varies depending on the cryptocurrency, as highlighted by the FTX downfall. Some advocate that cryptocurrency is an investment and a store of value, but I have taken a contrasting opinion which I outline in Crypto Is Not What You Think. Still, I have included cryptocurrency in this list since many consider it an alternative, and it has become more prevalent and mainstream.
Commodities are a broad asset class tied to tangible assets such as crude oil, agricultural crops, cattle, minerals, and more (sometimes including gold). They are traded either at their current (i.e., spot) price or future price through securitized contracts, which allow investors to speculate and participate in this market. Common ways to invest in commodities are electronically-traded products (ETPs), futures contracts, or through funds. These investments are not capital-intensive and are accessible to ordinary investors.
Certain REITs and real estate investments are considered alternatives. REITs refer to real estate investment trusts as defined by the SEC and receive preferential tax treatment due to their corporate structure. Private REITs that are not tradeable on exchanges and investing in physical real estate or syndicates are the typical real estate alternatives. These investments are (generally) not liquid and require higher investment minimums and net worth.
Private equity and credit include investing (equity) in non-publicly traded companies or loaning (credit) to companies. These investments are often illiquid, require high minimums, are only available to high-net-worth investors, and are (usually) fee-heavy. Advocates of private equity tout that more private companies exist than publicly traded ones and that these companies play an integral role in the economy, which traditional investing misses out on.
Hedge funds are similar to mutual funds in that they are investment vehicles that allow investors to pool their assets together under the direction of a manager. However, they differ because they often trade using exotic/risky investments or strategies to try and beat the market. Hedge funds are fee-heavy and have high minimums, illiquidity, less transparency, and require investors to be accredited.
Derivatives are an investment class partially credited with causing The Great Recession in 2007. Derivatives are contracts often known as futures or options and bind the parties involved together. These binding contracts derive value from an underlying device, which can vary from a specific asset(s) to benchmarks. Examples of assets include currencies, stocks, and bonds. Some derivatives are highly liquid and have few fees, such as stock options, while others are illiquid, custom-tailored, complex, and carry higher costs.
Antiques are a tangible asset class that includes various articles such as time-keeping devices, chinaware, clothing, etc. Some antiques are decades old, while some can date back over millennia. Antiques can vary wildly in liquidity and associated fees, but many are illiquid with high transacting costs. Further, forgery, storage, theft, and laws can hinder the viability of investing in antiques.
Art is an asset class as old as time, is generally less liquid, and has higher transaction fees. Examples of investing in this category include purchasing paintings, sculptures, and more by artists likely to continue to be recognized as desirable. Forgery, storage, and theft are substantial concerns in fine art. Notably, companies like Masterwork make investing in fine art easier for laypeople.
Why alternative investments have become more popular
Within the advisor and broader investing community, alternatives have become more prevalent in recent years as people have sought increased returns due to depressed interest rates that dominated the last decade. Examples include large advisor inflows into private equity funds and the increase of real estate investors (individual and institutional) during the past decade.
Another reason alternatives have become attractive is that some, but not all, have uncorrelated returns to the stock market. This added diversification benefit paired with potentially higher returns over standard investments has made alternatives more attractive to a broader crowd.
Are alternative investments worthwhile?
Alternatives are non-conventional assets that add complexity, illiquidity, high risk, and fees to investor portfolios. For most investors, this asset class is not suitable. Instead, these investors should focus on simplicity and low-cost investing by utilizing index funds.
Index fund investing is tried and true, and most actively managed funds or portfolios rarely beat their passive counterparts. (For a guide on choosing index funds, I suggest reading How To Choose the Best (#1) Index Fund.
Many alternatives, such as private equity and hedge funds, have hefty fees of 10-20% assessed on annual profits, plus a standard management fee of 1-2%. Consequently, outperformance is critical but never guaranteed, and most hedge funds underperformed the traditional 60/40 stock and bond portfolio from 2008 through 2021.
The longer an asset underperforms, the greater the future returns must be since you missed out on compounded growth. Further, fees and complexity make outperforming more difficult.
Countless investors in the alternative investment space are institutional players, such as private equity firms, pension funds, and hedge funds. These entities often have vast teams that oversee risk management and investment selection. Despite their sophisticated status, increased competition and added regulation have made it difficult for institutional players to outperform competitors and the broader market.
If you meet the SEC requirements to access specific alternatives by being an accredited or qualified investor, an advisor or purveyor of alternatives may offer them.
(Accredited investors must have an annual income of $200,000 for individuals ($300,000 for couples) for 2+ years or a net worth of at least $1,000,000. Qualified investors must have a net worth of $5m or more.)
Anytime someone offers you a potential alternative investment with great returns, realize those only exist due to increased risk, illiquidity, and other factors. Plenty of good alternative investment options exist, but most people can live without their downsides.
I plan to further explore the world of alternative investments in my future blog posts by honing in on more specific investments and examples to discuss their merits and drawbacks. But until then, let me know what questions or experiences you have with these investments in the comments below.
As always, have a great day!
What is an example of an alternative investment?
Examples include gold and other precious metals, cryptocurrencies, commodities, particular REITs and real estate investments, private equity and credit, hedge funds, derivatives, antiques, and art.
What are the key characteristics of alternative investments?
Defining attributes of alternative investments include potentially uncorrelated and higher returns, increased risk, substantial transaction fees, auxiliary costs, complexity, illiquidity (i.e., limited trading ability), limited transparency, and higher initial investment minimums.
Mile High Finance Guy
finance demystified, one mountain at a time