Alternative Investments: Definition, How it Works, Types, and More

Investors are always seeking to diversify their portfolios and generate higher returns. While traditional investments like stocks and bonds have been a staple in the investment world for years, alternative investments have become increasingly popular over the last decade.

This blog post aims to define alternative investments, explain how they work, explore the different types of alternative investments, and highlight their advantages and disadvantages.

Definition of Alternative Investment

Traditional investments include stocks, bonds, and cash equivalents. Alternative investments, on the other hand, are any investment that does not fall under the traditional investment category.

This can include a wide range of assets, from real estate and commodities to art and collectables.

One key characteristic of alternative investments is that they often have a low correlation to traditional investments. This means that they can provide diversification benefits to a portfolio.

How Alternative Investments Work

Due to their complexity, absence of regulation, and level of risk, most alternative investment assets are owned by accredited, high-net-worth individuals or institutional investors.

When compared to mutual funds and exchange-traded funds (ETFs), many alternative investments have high minimum commitment requirements and fee structures. Additionally, there are fewer opportunities for these investments to advertise to prospective investors and post verifiable performance data.

Although initial minimums and upfront investment fees for alternative assets may be high, transaction costs are usually lower than those for conventional assets because of lower levels of turnover.

Particularly when compared to their conventional peers, the majority of alternative assets are relatively illiquid.

For instance, due to a dearth of buyers, investors are likely to find it much harder to sell an 80-year-old container of wine than 1,000 shares of Apple Inc.

Due to the rarity of the assets and the deals involving them, investors may even find it challenging to value alternative investments. A seller of a 1933 Saint-Gaudens Double Eagle $20 gold coin, for instance, might find it challenging to estimate its worth given that only 13 of them are known to exist and only one of them is permitted to be legally possessed.

Read: All You Need To Know About Cryptocurrency

Types of Alternative Investments

Real Estate Investments

Some straightforward methods of investing in real estate include purchasing land, and homes, and collecting rental income or purchasing commercial property.

However, through Real Estate Investment Trusts (REITs), investors can also make secondary real estate investments. The low correlation between equity markets and real estate, which promotes the best inflation hedging, is what drives this form of business.

Related: How to Invest in Real Estate without Buying Property

Hedge Funds

A high return on investment is the main objective of hedge funds, which are investment funds that trade reasonably liquid assets and use a variety of investing strategies.

To implement their strategies, hedge fund managers can become experts in a range of disciplines, including long-short stock, market neutral, volatility arbitrage, and quantitative strategies.

Only institutional investors, including endowments, pension funds, mutual funds, and high-net-worth individuals are permitted to participate in hedge funds.

Private Equity

Private equity involves investing in private companies that are not listed on a public stock exchange. Investors in private equity typically seek to acquire companies to improve operations and sell them for a profit.

There are several subsets of private equity, including:

1. Venture capital is the financing of early-stage and fledgling businesses.
2. Buyouts, which occur when a business or one of its segments is completely acquired
3. Growth capital, which aids more established businesses in growing or restructuring.

The partnership between the investing business and the company receiving capital is a key component of private equity. Private equity firms frequently offer their investee businesses benefits beyond just capital, such as industry knowledge, help to find talent, and mentorship for startup founders.

Related: Private Equity Investing: Opportunities and Risks

Commodities

Commodities are physical goods like oil, gold, and agricultural products. Considering that they are not affected by public stock markets, commodities are regarded as a hedge against inflation.

Additionally, the price of commodities fluctuates according to supply and demand. As a result, greater demand for commodities drives up prices, which benefits investors.

Since they have been traded for thousands of years, commodities are hardly novel to the world of investing. The earliest organised commodity exchanges may have taken place in Osaka, Japan, and Amsterdam, Netherlands, in the 16th and 17th centuries, respectively. The Chicago Board of Trade began dealing in commodity futures in the middle of the 19th century.

Art and Collectables

Art and collectables like fine art, antiques, rare wines and vintage cars can be alternative investments. These investments can be difficult to value, but they can offer the potential for high returns.

Purchasing and maintaining tangible assets in the hopes that their worth will increase over time is the definition of investing in collectables.

The high costs of acquisition, lack of dividends or other income until they are sold, and possible destruction of the assets if not stored or cared for properly make these investments riskier than other types even though they may sound more entertaining and fascinating.

Experience is the most important skill needed to invest in collectables; you need to be a real expert to see a return on your money.

Cryptocurrencies & NFTs

Cryptocurrencies like Bitcoin and Ethereum have become increasingly popular as alternative investments. These investments are highly volatile and can be difficult to value, but they have the potential for high returns.

Digital goods on a blockchain that are non-fungible have their own distinctive and individual identification codes. Each “minted” NFT is unique and can neither be made again nor substituted. Although many digital products can be created as NFTs, digital art has been the most widely used application.

Related: Is It Worth Buying an NFT Today?

Advantages and Disadvantages of Alternative Investments

Advantages:

1. Diversification Benefits: Alternative investments can offer diversification benefits to a portfolio. Since they often have a low correlation to traditional investments, they can help to reduce overall portfolio risk.
   
   
2. Potential for High Returns: They can offer the potential for higher returns than traditional investments. This is because they are often riskier and less liquid than traditional investments.
   
   
3. Lower Correlation with Traditional Investments: Alternative investments can have a low correlation to traditional investments, which means that they can provide diversification benefits.
   
   

Disadvantages:

1. High Entry Barriers: Alternative investments often have high minimum investment requirements. This can make them inaccessible to many investors.
   
   
2. Lack of Liquidity: They are often less liquid than traditional investments. This means that they can be difficult to sell when investors need to raise cash.
   
   
3. Complexity and Lack of Transparency: Alternative investments can be complex and difficult to understand. This can make it difficult for investors to fully understand the risks associated with these investments.
   
   

Risks Associated with Alternative Investments

1. Liquidity Risk: Alternative investments can be less liquid than traditional investments. This means that investors may not be able to sell their investments when they need to raise cash.
   
   
2. Market Risk: Alternative investments can be highly dependent on market conditions. They can be affected by factors such as supply and demand, government policies, and global economic trends.
   
   
3. Operational Risk: Alternative investments can involve complex and risky operations. For example, real estate investments may require ongoing maintenance and management, while hedge funds may use complex trading strategies that can be difficult to execute.
   
   
4. Regulatory Risk: Alternative investments can be subject to different regulations than traditional investments. This can create additional risks for investors, as changes in regulations can impact the value of their investments.
   
   

Related: The Role of Risk Management in Investing

Factors to Consider When Investing in Alternative Investments

1. Investment Objectives: Investors should consider their investment objectives when choosing alternative investments. For example, if an investor is looking for income, they may want to consider real estate investments, while if they are looking for capital appreciation, they may want to consider private equity.
   
   
2. Risk Tolerance: Compared to conventional investments, alternative investments can be riskier. When selecting them, investors should take their risk tolerance into consideration.
   
   
3. Investment Horizon: Alternative investments can have long investment horizons. Investors should consider their investment horizon when choosing them.
   
   
4. Due Diligence: Alternative investments can be complex and risky. Investors should conduct thorough due diligence before investing in them. This can include researching the investment, understanding the risks associated with the investment, and evaluating the investment’s performance history.
   
   

Conclusion

Alternative investments can offer diversification benefits and the potential for higher returns, but they also come with additional risks and complexities.

Investors should carefully consider their investment objectives, risk tolerance, and investment horizon, and conduct thorough due diligence before investing in alternative investments.

By doing so, they can make informed investment decisions and potentially benefit from the advantages of alternative investments while managing their risks.

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