WTF Are Alternative Investments?
When it comes to investing, millions of Americans typically use traditional asset classes such as stocks, bonds, and cash. Unfortunately, investors must endure painful bouts of market volatility. But alternative investments offer a second suite of non-traditional asset classes. These give investors the freedom to make money beyond humdrum stocks and bonds.
Alts can help investors protect their money from sharp market declines or earn even bigger investment returns. They’re best used to diversify an already-established traditional portfolio, and they range from dairy cows and rental properties to emerging startups and complex investing strategies.
How Many Alternative Investments Are Available to Investors?
Around a dozen alternative asset classes are available to investors who tend to be wealthy individuals, investment banks, endowments, and pension funds. These are called accredited investors. They can afford the large initial investment buy-ins required by most alts, effectively making them off limits to small-timers.
But some alternative investments are open to any investor, and it’s possible you may be invested in an alt through your 401(k) or government pension plan. For example, I have an index fund in my retirement plan that invests in alts. It’s been nice diversifier and a top performer for nearly 20 years.
If you’re invested in alts, it’s likely via a target-date fund, a highly diversified mutual fund comprised of dozens of stock and bond mutual funds.
What Are the Most Popular Alternative Investments?
To keep it simple, here’s a list of the six most widely used alternative investments by both retail and accredited investors:
- Hedge funds
- Managed futures
- Real estate
- Private equity
- Venture capital
Commodities are investments in Planet Earth. Or basically what clothes, feeds, and shelters us, as well as powers our cars and computers, among a million other things. Commodities include crops and livestock, fossil fuels like oil and coal, and precious metals such as copper and gold.
To make money, investors make bets on the rise and fall of prices — future prices for the raw materials (crude oil) and future prices for the finished product (gasoline).
That said, betting on the future is risky business, and betting on commodity prices is even riskier.
A powerful storm, for example, could destroy most of America’s corn crop in days and drive up prices based on scarcity demand. That’s why these short-term investing strategies are left to the professionals and not to the retail investor.
However, the small investor still has a way to invest in commodity prices safely. Buy an exchange-traded fund (ETF) that purchases the actual commodities, such as gold or timberland. It’s best to look for an ETF that purchases several different commodities, which makes them less volatile when prices start going crazy. This is called diversification.
2. Hedge Funds
Think mutual funds that are private, secretive, and a bit edgy. Hedge funds are Wall Street’s little plaything for the rich and powerful — their own private investment market with little government oversight.
These funds can raise money from investors and enjoy broad flexibility to buy or sell a wide range of assets as fund managers seek to outperform the regular bond and stock markets. The one trait that makes them unique is that they seek to profit not only from economic growth, but also from market inefficiencies.
Hedge funds are regarded as the exclusive bastion of the rich, and they are.
To join one, you must be an accredited investor who can handle a typical fund’s fee structure. This requires a flat two percent fee on total assets under management and an additional 20 percent on the fund’s profits. Some funds charge much more.
Personally, I think most hedge funds are bullshit. Despite the hype of super performance, many have failed and closed.
3. Managed Futures Funds
This alternative investment works much like a hedge fund. Managed futures funds are operated by fund managers who collect money from investors and invest in a broad range of assets.
More regulated than hedge funds, managed futures funds make speculative bets on, viola, the future. Namely the future prices of commodities, currencies, and interest rates. These funds use two complex financial products to do this: futures and options.
Futures are contracts to buy a commodity or currency at a set price and date. Profits depend on whether the actual price is higher or lower than the agreed upon price. Options function in the same way, but investors have the option to buy or sell the asset at a predetermined date and price.
Retail investors who seek diversity for their portfolios can buy into managed futures funds for less than $10,000. But betting on future prices is risky business and better left to the professionals.
4. Real Estate
This is the most democratic alt investment, a proven money maker that’s so easy to get into. You probably already know the drill on real estate investing: You can buy a rental property on your own and rent it out (forget flipping).
If that doesn’t float your boat, you can become a partner in a real estate investment group, which invests in companies that purchase and manage condos and apartments. Or you can buy shares in a real estate investment trust, or REIT.
A REIT is simply a company with special tax status that owns and manages all sorts of commercial and residential properties. In this way, it produces a steady income stream that it returns to investors as dividends.
REITs are one of my favorite investments.
I’m exposed to them in my 401(k) via the Vanguard Real Estate Index Fund, which tracks the performance of some 80 REITs around the world. It’s been a low-cost, steady-eddy performer for years.
5. Private Equity
There are thousands of companies in the U.S. and around the world that don’t sell stock and strive to remain private. So how do they raise capital to grow? Enter the private-equity (PE) investor — namely wealthy individuals, endowments, and pension funds.
PE investors form private-equity firms to invest directly into established companies with reliable revenue streams. They also target companies — some with once-profitable and notable histories — that are down in the dumps and in need of a management revamp. And PE investors aren’t passive. They often help shape and manage the company.
Sometimes investors use borrowed money as “leverage,” which means their profits get magnified. PE investors profit when a target company is sold or goes public (management starts selling stock).
Again, private equity is mainly for wealthy, accredited investors. But retail investors can also get exposure by buying stock of private-equity companies like Blackstone and the Carlyle Group, or by purchasing ETFs that track an index comprised of dozens of publicly traded private-equity firms.
6. Venture Capital
Venture capital (VC) works much like private equity. Investors form venture-capital firms to fund private companies. But in contrast to PE investors, VC investors target unproven startups in their early stages. They provide capital critical to the business’s development.
But VC investors must tolerate more risk and less control over a startup’s management. Like with PE, investors in startups make money when the company is sold or issues stock. The wait time for VC investors to see a return could be 10 or 20 years, and it’s hard to pull out your money (highly illiquid). VC investing is mainly for accredited investors.
Final Thoughts: What about Hard Assets?
Investors who can’t stand betting on commodity prices or being a landlord can find profitable returns by buying rare and expensive artworks, coins, and wines. Some buy vintage cars and planes. Really anything of value and age.
As with venture capital, these investors aren’t looking to make a quick profit. They’re likely to be more motivated by their love of art, a rare merlot, or an old Duesenberg than earning big returns.
Alternative investments come in all shapes and sizes and may not be suitable for many investors. However, it’s good to know that investors have more opportunities to make money beyond traditional investing.
Do your research and enlist the help of trustworthy financial advisers.