Investors diversify their capital across several assets to mitigate risk. Most investors put their money into stocks, bonds and cash. While some investors pick individual investments, others achieve quick diversification through an exchange-traded fund, or ETF.
While traditional assets are popular choices and can generate good returns, you may be missing out if you don’t consider alternative investments. These investments can outperform traditional assets and minimize your downside during economic uncertainty.
Understanding how alternative assets work can help you decide if they make sense for your portfolio. Start with this overview of your options:
Alternative investments cover a wide range of assets. It’s challenging to list every opportunity under this umbrella, as people invest in everything from whisky to fine wine and classic cars, but there are a few standout categories.
Kelly Milligan, managing partner at Quorum Private Wealth, explains how investors can distinguish alternative investments: “The easiest way to define ‘alternative investments’ may be to describe what they are not. They are not ‘traditional investments’ – that is – publicly traded stocks and publicly traded bonds,” she states. “The term ‘alternative investments’ can describe a wide range of opportunities, including private equity, private credit, commercial real estate, commodities, hedge funds, physical metals, even portfolios of railroad boxcars, farmland or museum-quality artwork.”
Investors flock to these assets for high potential returns and less correlation with the stock market. Some alternative investments can gain value as the stock market enters a correction. For instance, gold tends to gain value during economic uncertainty, while equities often lose value in that environment. Many alternative assets serve as useful hedges.
Many assets are treated as alternative investments. Buying collectibles, flipping websites and collecting stamps are some of the ways you can participate in alternative investing. While the category is broad, these are some of the more common alternative investments that you may encounter:
Real Estate
Properties tend to gain value over time due to their limited supply. Some investors generate cash flow with real estate, while others aim to fix up and flip properties.
Investors with more capital can get involved in commercial real estate, health care real estate, warehouses and other expensive ventures. Investors with less capital can get started with real estate investment trusts, or REITs.
Precious Metals
Gold, silver and cobalt are examples of precious metals. These resources are important for society because of their use in various products. For instance, cobalt is in cars, semiconductors and jewelry. Gold is notable for its status as an inflation hedge.
Commodities
Precious metals are a type of commodity. These assets consist of basic goods and materials that are important for everyday life. Crops, livestock and oil are commodities.
Private Equity
Investors can pool their money into private equity to acquire companies that are not publicly traded. Some people venture into this asset class alone, while others team up with likeminded investors to raise more funds.
Hedge Funds
Hedge funds offer portfolio diversification similar to mutual funds. However, hedge funds have more flexibility with the investment vehicles they can use. For instance, hedge funds can short equities, accumulate commodities and trade derivatives. Mutual funds do not have this flexibility.
Hedge funds are riskier but can generate higher returns, and most of them are only available to accredited investors.
Cryptocurrencies
These digital currencies operate on decentralized blockchain systems and have sharp volatility. Some people exchange cryptocurrencies for goods and services. Bitcoin (BTC) and Ethereum (ETH) are the two largest and most established cryptocurrencies.
Fine Art
Beauty is in the eye of the beholder, and some fine art continues to gain value over time. Investors can either buy shares in a fund that holds fine art investments or buy art themselves and put it in good storage.
Alternative investments offer several advantages over traditional assets that can lead to a well-diversified portfolio. A key distinction alternative investments have is how different they are from stock and bond returns.
Diversification for Lower Volatility
“The primary advantages of alternative investments are that they tend to be less correlated to traditional stocks and bonds, and returns of some alternative investments have been quite attractive over time. By diversifying into other types of assets that might produce different return patterns, investors can often achieve higher portfolio returns with lower overall volatility or risk,” Milligan explains.
Milligan goes on to highlight how several alternative investments outperformed stocks and bonds in 2022, a year that traditional investors want to keep in the rearview mirror: “Traditional stocks and bonds were both down double digits, but many hedge funds, private credit and commercial real estate funds were positive.”
Inflation Hedge
Alternative investments can act as a cushion from a stock correction and often act as inflation hedges. If inflation goes up, the price of raw materials and basic necessities will also go up. Commodities, properties and other alternative investments have built-in protections that most traditional assets lack. These assets can generate positive returns during bull runs instead of relying on something to break in the economy to reward shareholders.
Higher Annualized Returns
Alternative investments can do more for your money than if you keep it in the bank. A higher annualized return on your capital can help you achieve long-term financial goals sooner and give you more choices in retirement.
Alternative investments can sound exciting, especially with Bitcoin more than doubling over the past year. However, it’s important to consider some of the risks before getting started.
Less Accessible Funds
Peter J. Klein, chief investment officer and founder of Aline Wealth, mentions some concerns to keep in mind, including the lack of liquidity. “By nature, alternative investments lack liquidity, meaning that an investor’s funds may be locked away for an extended period, roughly between five to seven years or even up to 10 years,” he says.
While cryptocurrency trades can take place in real time, it can take much longer to get your money out of a hedge fund or a real estate syndicate. It can also take several months or years to sell a real estate property. You may also need to put a lot of capital into a single asset. This truth is more pronounced for real estate investors.
Additional Tax Requirements
Alternative investments can further complicate your taxes by requiring additional forms. You also have less control over your total capital gains because the fund manager can sell assets at any time. These assets can outperform stocks and bonds, but it’s still possible for alternatives to underperform traditional investments.
“From June 2006 to June 2022, research from Dimensional revealed that U.S. liquid alts funds underperformed against broad equity and fixed-income market indexes,” Klein adds. “Furthermore, liquid alts might not provide the desired diversification, as these funds are often built on the same principles as the global stock and bond market.”
Alternative investments can deliver respectable returns for long-term investors. These assets do not correlate with stock market returns, which gives investors more flexibility.
You can invest in alternative assets by acquiring assets on your own, putting your money into a fund or teaming up with other investors.
Investors should consider their liquidity needs, time horizon, risk tolerance, portfolio size and objectives before accumulating alternative assets. It takes more effort and often extra capital to get involved with alternative investments. However, the diversification and potential returns can make it worth the effort.