A financial asset that does not fit into one of the traditional investment categories is known as an alternative investment. Typical categories include securities like stocks, bonds, and cash. Private equity or venture capital, hedge funds, managed futures, art and antiquities, commodities, and derivatives contracts are examples of alternative investments. Another popular category for alternative investments is real estate. These conventional assets, like the index fund in your 401(k) or the cash in your savings account, are typical for most individual investors. But that only gives a partial view. Beyond traditional investments, there is another type of investing known as alternative investments.
What are alternative investments?
The majority of alternative investment assets are held by accredited, high-net-worth individuals, or institutional investors because of their complexity, lack of regulation, and level of risk. A lot of alternative investments have higher minimum investment requirements and cost structures than mutual funds and exchange-traded funds (ETFs). Additionally, these investments have less options to attract new investors and offer verifiable performance data. Although alternative assets may have higher beginning minimums and upfront investment costs, transaction costs are frequently cheaper than those for traditional assets due to lower levels of turnover.
Particularly when compared to their conventional equivalents, the majority of alternative assets are very illiquid. For instance, due to a dearth of buyers, investors are likely to find it far harder to sell an 80-year-old bottle of wine than 1,000 shares of Apple Inc. Due to the rarity of the assets and the transactions surrounding them, investors may even find it challenging to value alternative investments. A seller of a 1933 Saint-Gaudens Double Eagle $20 gold coin, for example, could 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 lawfully held.
How to regulate alternative investments?
Alternative investments are susceptible to investment fraud and scams due to a lack of regulations, especially when they don’t include rare items like coins or works of art. Compared to standard investments, alternative investments may be subject to a less clear legal framework. They are covered under the Dodd-Frank Wall Street Reform and Consumer Protection Act, and the U.S. Securities and Exchange Commission (SEC) is tasked with investigating their operations. They typically aren’t required to register with the SEC, though. As a result, unlike mutual funds and ETFs, they are not supervised or controlled by the SEC.
Therefore, when considering alternative investments, investors must conduct extensive due research. Only accredited investors are permitted to purchase some alternative goods. A person is considered an accredited investor if they have a net worth of at least $1 million (excluding their primary property) or an annual income of at least $200,000 (or $300,000 when including a spouse’s income). Accredited investors may also include financial professionals who hold a FINRA Series 7, 65, or 82 license.
Seven different types of alternative investments
1. Private equity
The wide term “private equity” refers to financial investments made in privately held businesses or those that are not publicly traded on a stock market like the New York Stock Exchange. Private equity is divided into a number of categories. The first category is venture capital which concentrates on start-up and early-stage businesses. Then, the next category is growth capital which aids more established businesses in expanding or restructuring. Finally, there are the buyouts which involve the outright purchase of an entire company or one of its divisions. The partnership between the investment business and the company receiving funds is a key component of private equity. Private equity firms frequently offer their investee companies services beyond just funding. The services cover market knowledge, help finding talent, and coaching for startup founders.
2. Private debt
Private debt refers to investments that are not purchased on the open market or financed by banks (i.e., a bank loan). Since both public and private companies can borrow money using private debt, it’s important to note that the word “private” refers to the investment vehicle rather than the debt borrower. Leveraged private debt is used by firms when they require additional funding to expand. Private debt funds are the businesses that issue the capital. They normally generate revenue through interest payments and loan repayment.
3. Hedge funds
A high return on investment is the main objective of hedge funds. They are investment funds that trade reasonably liquid assets and use a variety of investing strategies. To implement their strategies, hedge fund managers might become experts in a range of disciplines. These involve long-short equities, market neutral, volatility arbitrage, and quantitative methods. Only institutional investors, including endowments, pension funds, mutual funds, and high-net-worth individuals are permitted to invest in hedge funds.
4. Property
Real assets come in a wide variety of forms. Real assets include things like land, timberland, farming, as well as intellectual property like artwork. However, real estate is the most prevalent and largest asset class in the world.
Real estate is an intriguing category not only because it is large, but also because it resembles equity and bonds in that property owners receive present cash flow from renters, or capital appreciation. They also aim to raise the asset’s long-term worth. The difficulty of valuing exists in real estate investing as it does in other real assets. Methods for valuing real estate include income capitalization, discounted cash flow, and sales comparative, each with advantages and disadvantages.
5. Commodities
Commodities, which are mostly natural resources like agricultural products, oil, natural gas, and precious and industrial metals, are also actual assets. Considering that they are not affected by public equities markets, commodities are regarded as a hedge against inflation. In addition, supply and demand affects how much a commodity costs. As a result, rising commodity demand raises prices, which is good for investors.
Since they have been traded for thousands of years, commodities are scarcely new to the world of investment. The earliest official 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.
6. Collectibles
Rare wines, vintage automobiles, great paintings, mint-condition toys, stamps, coins, and a broad variety of other goods are examples of collectibles. Investing in collectibles is the process of acquiring and maintaining physical assets with the expectation that their value will rise over time. The high costs of acquisition, lack of dividends or other income until they are sold, and potential 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 interesting. Experience is the most important talent needed to invest in collectibles. You need to be a true expert to see a return on your money.
7. Structured products
Structured products typically include derivatives, or securities whose value derives from an underlying asset or collection of assets. Those include stocks, bonds, or market indices, as well as fixed income markets, or those that give investors dividend payments like government or corporate bonds. Credit default swaps (CDS) and collateralized debt obligations are a couple of examples of structured goods (CDO). Despite the fact that they can be complicated and occasionally risky investment products, structured goods give investors a product mix that is specifically tailored to their needs. Usually, investment banks produce them and offer them to hedge funds, businesses, or individual investors.
