ALTERNATIVE INVESTMENTS FOR BEGINNERS

You need to know that there’s more to investing than just stocks and bonds.

Alternative investments frequently surface as options for investors who are looking for ways to change their volatility exposure and potentially generate additional returns beyond holding stocks and bonds. For the right investor, alternative investments can be a compelling choice for a diversified portfolio.

Alternative investments consist of a wide range of assets that are outside of the “core” asset classes of cash (and equivalents), stocks, and bonds. Investors use alternative investments to diversify their portfolios or to capitalize on timely market conditions, special interests, or unique bases of knowledge.

WHAT IS AN ALTERNATIVE INVESTMENT?

To appreciate how alternative assets are defined, you need to understand two related concepts known as “asset classes” and “asset allocation.”

An asset class is a type of asset that has a certain set of characteristics. There is a handful of what can be considered “core” asset classes that someone might consider adding to their investment portfolio. They include Cash and cash equivalents, Stocks, Bonds.

In its broadest sense, an alternative investment, or alternative asset, is any type of asset that does not fall into one of these three categories. The way you divide your investments among the different kinds of assets is asset allocation.

HERE ARE SOME TYPES OF ALTERNATIVE INVESTMENTS:

⦁ Hedge Funds:

Hedge funds are investment funds that trade relatively liquid assets and employ various investing strategies with the goal of earning a high return on their investment. Hedge fund managers can specialize in a variety of skills to execute their strategies, such as long-short equity, market neutral, volatility arbitrage, and quantitative strategies. Hedge funds are exclusive, available only to institutional investors, such as endowments, pension funds, and mutual funds, and high-net-worth individuals.

⦁ Real Estate

There are many types of real assets. For example, land, timberland, and farmland are all real assets, as is an intellectual property like artwork. But real estate is the most common type and the world’s biggest asset class. In addition to its size, real estate is an interesting category because it has characteristics similar to bonds — because property owners receive current cash flow from tenants paying rent — and equity, because the goal is to increase the long-term value of the asset, which is called capital appreciation.

⦁ Private Equity

Private equity (PE) is ownership or interest in an entity that is not publicly listed or traded. A source of investment capital, private equity comes from high-net-worth individuals and firms that purchase stakes in private companies or acquire control of public companies with plans to take them private and delist them from stock exchanges.

An important part of private equity is the relationship between the investment firm and the company receiving capital. Private equity companies often provide more than capital to the firms they invest in; they also provide benefits like industry expertise, talent sourcing assistance, and mentorship to founders.

⦁ Private Debt

Private debt refers to investments that are not financed by banks, for example, bank loans or traded on an open market. The “private” part of the term is important — it refers to the investment instrument itself, rather than the borrower of the debt, as both public and private companies can borrow via private debt.

Private debt is leveraged when companies need additional capital to grow their businesses. The companies that issue the capital are called private debt funds, and they typically make money in two ways: through interest payments and the repayment of the initial loan.

⦁ Commodities

Commodities are also real assets and mostly natural resources, such as agricultural products, oil, natural gas, and precious and industrial metals. Commodities are considered a hedge against inflation, as they’re not sensitive to public equity markets. Additionally, the value of commodities rises and falls with supply and demand — higher demand for commodities results in higher prices and, therefore, investor profit.

Commodities are hardly new to the investing scene and have been traded for thousands of years. Amsterdam, Netherlands, and Osaka, Japan may lay claim to the title of the earliest formal commodities exchange, in the 16th and 17th centuries, respectively. In the mid-19th century, the Chicago Board of Trade started commodity futures trading.

SOME PROS AND CONS OF ALTERNATIVE INVESTMENTS

Before making alternative investments, it’s wise to be aware of their potential benefits and drawbacks.

⦁ Benefits

Possibility of tax-advantaged or sheltered cash flows

Less-efficient markets that can lead to opportunities

Intellectual and emotional satisfaction

⦁ Drawbacks

Possibility of negative tax consequences

Lack of transparency, resulting in significant hidden risks

More complicated investments.

WHY INVESTORS SEEK OUT ALTERNATIVE INVESTMENTS

There are several reasons an investor or a portfolio manager is likely to consider adding alternative investments to a balance sheet.

⦁ Favourable Conditions

In other cases, factors and conditions specific to a particular asset class at the time the investment is considered might make the asset class appear significantly cheaper, and thus more attractive for a long-term owner, than other types of investments available in the market. For example, there was a period during the aftermath of the Great Recession when wealthy investors were buying deeply discounted condos in cities such as Miami and paying a fraction of what they thought the ultimate market value would be in the future.

⦁ Unique Skills or Knowledge

Sometimes, the investor or their advisors have deep knowledge — or unique skill set in a specific area — that can cause alternative investments to make sense to them. For example, if an experienced entrepreneur in the oil and gas industry had the resources and patience to take advantage of a major oil or gas glut, that unique knowledge and experience might pay off handsomely.

⦁ Intellectual Interest

In other situations, a particular alternative investment or alternative asset class might emotionally and intellectually hold the attention of the investor more than other asset classes. For example, there are successful investors who are deeply drawn to venture capital because they enjoy the process of identifying, funding, and taking ownership in startups and relatively new enterprises.

⦁ Control

There are some investors who do not like owning stocks and bonds, preferring to underwrite their own mortgages on real estate properties they have acquired and renovated. It makes sense to them. They feel that they can better understand the potential gains and losses, especially when compared to the volatility of owning a publicly traded common stock.

⦁ Cooperation

There are some investors who acquire catalogues of music copyrights, either at auction, in negotiated transactions, or through bankruptcy court proceedings, because they understand how to administer and license those rights to interested parties.