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Introduction to alternative investments
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What are alternative investments?
Equities and fixed income – aka stocks and bonds – are the mainstay of many investors’ portfolios.
But beyond these traditional asset classes and others lies a whole world of “alternatives.”
These include institutional alternative investments such as private equity, private credit, hedge funds and real assets.
“Real assets” can embrace the likes of real estate, commodities and infrastructure.
Let’s quickly explore the make-up of some of the main alternative asset classes.
Many hedge funds invest in the same assets as traditional funds, such as equities and fixed income.
What makes them “alternative” is typically their investing strategies, which may be more sophisticated and riskier than those of traditional funds.
Private equity means owning shares in businesses that are not publicly traded, either directly or indirectly.
Most often, this is done indirectly via a specialist private equity fund, whose managers raise money from investors and then invest that money across a selection of companies in the fund.
Real estate consists of commercial properties (e.g., offices, shops, hotels and warehouses) and residential (e.g., homes).
Ways for investors to own real estate include stock market strategies exposed to many properties and owning individual buildings directly.
Commodities embrace a wide range of tangible materials used to make other things.
These include metals (copper, gold and so on), energy (including oil and gas) and agricultural (such as crops, livestock and meat).
Metals embrace industrial inputs such as copper and aluminum as well as the precious metals gold and silver.
Energy is made up of the likes of crude oil, natural gas and coal.
Agricultural commodities are things like coffee, wheat, cotton and lumber. Livestock and meat include live cattle and beef.
So, what’s “alternative” about alternatives?
The label “alternatives” might seem confusing at first.
As we’ll see, suitable investors tend to not treat private equity, real estate and so forth as something to hold instead of stocks and bonds.
Rather, suitable investors almost always combine alternative and traditional asset classes within diversified portfolios.
One way in which alternatives can be alternative, though, is in how they perform during certain market environments.
Put simply, historically these asset classes have the potential to perform differently to equities and bonds for at least some of the time.
Importantly, though, that may not always hold true in all market environments.
How do alternatives fit into a portfolio?
Alternatives are certainly not for every portfolio and investor.
Suitable investors need to qualify to invest in alternatives. This means having sufficient wealth and understanding of the risks of the asset class.
For suitable investors, though, alternatives may offer the potential to diversify portfolios.
This comes back to how they have often performed.
Real estate, for example, may be doing well at a time when equities are struggling and vice versa.
As well as potential capital growth and diversification, alternatives such as real estate may also pay out income.
In real estate, the rents and capital gains earned may be used to make payments to investors.
Likewise, some private equity and hedge funds make income-like distributions to investors.
The risks of alternative investing
Alternative asset classes come with many risks.
Especially if an alternative strategy uses borrowed money – or leverage – there’s a risk that an investor can lose all of what they put in.
During bouts of market stress – such as the Global Financial Crisis of 2008–09 – some alternative asset classes such as private equity can fall even more than equities.
Illiquidity is another major feature of many alternative investments.
Many private equity and real estate managers, for instance, require investors to commit their capital for several years.
Getting out before the end of the strategy’s lifetime may not be possible. And if it is possible, investors may only be able to sell out at a big discount to what they paid.
On top of investment risks, there may be operational risks.
Alternatives: the bottom line
Over time, investments many suitable investors have devoted part of their portfolios to alternatives.
Indeed, many large institutional investors have increased their holdings of asset classes such as private equity and real estate in recent decades.
However, this increased appetite for alternatives brings risks of its own, in addition to those already discussed.
As more investor money flows in, for example, private equity managers can potentially end up overpaying for assets.
In such an environment, lower returns and greater losses during downturns become more of a concern.
Rigorous insights, monitoring and risk mitigation efforts are vital for anyone investing in alternatives.
KEY TAKEAWAYS:
Commodities, private equity, hedge funds and real estate are among the most common alternative investments.
For suitable investors, alternatives are best used to complement a traditional asset allocation, which typically includes stocks, bonds and cash.
Investing in alternative assets can potentially help with diversification, increase returns and hedge against inflation, but it also comes with greater risk.
Among the many risks of alternatives are typically a complete loss of capital if a strategy goes wrong, less liquidity, less transparency into many private funds and operational risks.
