Alternative investments, like cryptocurrencies, private equity, hedge funds, art, etc., have become more popular, especially with younger people and the wealthy.
But many of these investments carry greater risk because they are often illiquid and are lightly regulated. Most investors are familiar with stocks, bonds, mutual funds, and ETFs (exchange-traded funds). These are liquid investments regulated by the U.S. Securities and Exchange Commission (SEC) because they are offered publicly.
However, alternatives are moving into the mainstream, but they have risks.
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Investors are More Interested in Alternative Investments
Despite the risks, investor interest in alternative investments is rising. For example, a relatively recent KKR survey of family offices indicated ultra-high-net-worth families with more than $1 billion to invest place about 51% to 54% of their total assets in alternative investments.
The percentage declines as wealth decreases, but younger investors are attracted to alternatives. A Bank of America survey showed 80% of young investors are looking for alternative investments. On the other hand, people over the age of 43 prefer equities. In addition, newer investors do not believe they can achieve above-average returns with only stocks and bonds.
This rising interest has caused assets under management (AUM) to increase in alternative investments. For example, AUM in private equity grew at a 13.9% compound annual growth rate (CAGR) between 2015 and 2023 in private capital. As a result, the value climbed to $8.9 trillion from $4.08 trillion. Growth is expected to accelerate and reach $17.77 trillion by 2026.
A similar trend is occurring across other alternative asset classes.
Does Alternative Investment Provide Diversification?
Many investors have retirement and taxable portfolios concentrated in equities, fixed income, and cash. Nearly 46% of people in the United States own mutual funds and approximately 56% own stocks.
Conventionally equities and bonds were viewed as uncorrelated. But the market always surprises, and the period of climbing interest rates in response to spiking inflation caused both stocks and bonds to decline.
Other types of investments can provide diversification to portfolios. For instance, gold is viewed as an inflation hedge and is uncorrelated to equities and bonds. More illiquid asset classes, like collectibles or hedge funds, may also provide diversification. But they are difficult to buy and sell, have minimum investment requirements, and come with greater risk.
Investing in alternative investments is risky. First, many are not traded on an exchange, like some collectibles, private equity, and structured products. This fact makes them more challenging to value and thus buy and sell quickly. Next, the trading volume is often low, unlike Apple stock. Lastly, regulation is often light or limited even when an asset, such as cryptocurrency, is traded on an exchange.
Furthermore, alternative investments are typically available only to accredited investors. That said, some types of alternative investments are suitable for many people depending on their goals. Talking with a licensed financial advisor is wise if you are considering investing in these asset classes.
Types of Alternative Investments
Gold is an alternative investment, popular during periods of high inflation or global turmoil. The metal was used for currency in ancient times and had one of the longest histories as an alternative investment. Today, people invest in gold to diversify their holdings and act as a protection against inflation and deflation.
It is widely viewed as a store of value—consequently, governments worldwide purchase and own gold as reserves. The United States owns the largest gold reserves at about 8,134 tons worth more than $500 billion on the spot market.
But gold has disadvantages too. It does not pay interest or a dividend. Because of its weight, the storage of physical gold is tricky. Additionally, gold has underperformed for long stretches.
Ways to Buy Gold
Investors can buy gold jewelry, coins, and bars if they wish to own them physically. However, the more straightforward method to own gold is through a mutual fund or ETF. The biggest gold ETF is SPDR Gold Shares (GLD), which offers a way to own gold indirectly. Several other gold ETFs exist. Another way to invest in gold is by purchasing stock of mining companies like Barrick Gold (GOLD), Newmont (NEM), and Franco-Nevada (FNV).
Gold is not appropriate for everyone, but it has a place in some portfolios.
Cryptocurrencies are the second alternative investment on this list. But they are a relatively new type of investment that has moved from obscurity to the mainstream. Cryptocurrencies can be bought and sold on dedicated exchanges, like Coinbase. Many fintech apps also let people buy and sell cryptocurrencies. Also, it’s possible to mine some cryptocurrencies, like Bitcoin (BTC), if you have the servers and algorithms.
Today, there are thousands of cryptocurrencies, and the total market is estimated at roughly $1 trillion, down from its all-time peak. However, not all cryptocurrencies are the same, even though they are all based on blockchain technology. Moreover, the risk level varies between currencies because of liquidity differences, whether coins or tokens, how they are produced, acceptance for trade and purchases, and regulation.
Some cryptocurrencies were compared to gold and viewed as a store of value and hedge against inflation or deflation. But high inflation and rising interest rates showed cryptocurrencies do not behave like gold as their prices crashed.
Focus on Liquidity and Well-Known Names
If you choose to invest in cryptocurrencies, stick with well-known exchanges and the most liquid coins or tokens. Currently, the leaders by market capitalization are Bitcoin, Ethereum (ETH), and Tether (USDT). The three have relatively high trading volume too.
However, investors should be knowledgeable about the risks of this alternative investment. The asset class is very volatile, and there is significant regulatory risk. Hence, cryptocurrencies are not for everyone.
Purchasing real estate for income or capital appreciation makes it an alternative investment. But your primary home does not count as an investment. However, many investors own residential rental properties to generate passive income. Other investors buy, fix, and flip homes and condominiums, focusing on higher resale values.
But real estate has some risks too. First, it ties up capital because a down payment is necessary. For example, buying a second or third home to rent to tenants usually requires a 20% down payment. You must also deal with insurance, property taxes, maintenance, bad tenants, etc. Lastly, home prices can decline, like during the Great Recession and the inflationary period after the COVID-19 pandemic.
Besides residential real estate, investors can acquire commercial rental properties. But this often requires more expertise and initial principles than the average investor has available.
Real Estate Investment Trusts
Buying and selling shares of real estate investment trusts (REITs) is an alternative method to invest in real estate. They are equities typically traded on stock exchanges. But REITs differ from stocks and bonds and are viewed as an alternative investment to provide diversification. In addition, they are pass-through entities and distribute 90% of their taxable income as dividends, limiting corporate taxes. As a result, REITs usually have high dividend yields.
Many different REIT types exist. The list includes net lease, data center, self-storage, apartment, mortgage, industrial, hospitality, timberland, healthcare, office, diversified, and specialty REITs.
On the negative side, the dividend tax rate of REITs is the same as ordinary income. REITs can be volatile and have poor returns during recessions. The sub-prime mortgage and the COVID-19 pandemic are examples of when REIT stock prices plunged. In addition, they are prone to dividend cuts during difficult economic times because they issue debt or equity for growth.
However, REITs have had periods of high returns, performing better than stocks and bonds.
Commodities are yet another alternative investment. They are bought and sold on dedicated exchanges, like stocks and ETFs. The leading American commodities exchange is the CME Globex Trading System.
Raw materials, farm products, and mining output are classified as commodities. Examples include oil, natural gas, coal, steel, wheat, cows, coffee, etc. Mass-produced items are also commodities, like chemicals and computer memory chips. Gold is also considered a commodity but is in its own category for alternative investments.
The price of commodities fluctuates based on demand and supply. Therefore, from an investor’s perspective, they can act as an inflation hedge because their prices rise during these times.
Institutions and trading firms typically trade commodities. Most retail investors will probably not directly buy and sell commodities, futures, or options. Instead, they will invest in commodity ETFs. They have made it much easier for small investors to participate in this part of the market. For example, the United States Oil Fund LP (USO) tracks oil futures contracts.
Investing in collectibles, like art, has been the purview of the ultra-rich for centuries. To acquire a masterpiece, like the work of Picasso, takes millions of dollars. Challenges like valuation, fakes, lack of income, and illiquidity also keep most people out of the art market. However, new platforms such as Masterworks have made investing in art simpler.
Besides art, people collect coins, trading cards, wine, comic books, classic cars, antiquities, toys, sneakers, and more. Of course, in many cases, one must buy and sell the actual items, but trading platforms exist for almost all collectibles.
Collectibles can provide returns on par with stocks and bonds if you know what you are doing. For truly rare items, the returns have been outstanding. For example, a mint condition 1952 Mickey Mantle Topps rookie card was bought in 1991 for $50k. It was sold in July 2022 for $12,500,000. In another example, many original and limited edition Air Jordan sneakers sell for hundreds of thousands to millions of dollars.
Other Alternative Investments
Many other alternative investments exist. But they are typically available to the rich with sufficiently high net worth and liquidity. This list includes private equity and debt, hedge funds, farmland, venture capital, angel funds, structured products, business development companies (BDCs), etc.
Some of these types of asset classes are only available to accredited investors. However, accessing other alternative investments takes a net worth of tens of millions and sometimes at least $1 billion.
Know the Pros and Cons Before You Invest
Alternative investments are products besides conventional stocks, bonds, mutual funds, ETFs, and cash. They are a way to diversify your total portfolio and sometimes protect against inflation. Certain types of alternatives are also lovely for personal enjoyment. But they are not for everybody because of the risks. They usually have higher fees, limited regulation, less transparency, and a lack of liquidity.
The fundamental point is investors need to understand the pros and cons before they invest.
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Prakash Kolli is the founder of the Dividend Power site. He is a self-taught investor, analyst, and writer on dividend growth stocks and financial independence. His writings can be found on Seeking Alpha, InvestorPlace, Business Insider, Nasdaq, TalkMarkets, ValueWalk, The Money Show, Forbes, Yahoo Finance, and leading financial sites. In addition, he is part of the Portfolio Insight and Sure Dividend teams. He was recently in the top 1.0% and 100 (73 out of over 13,450) financial bloggers, as tracked by TipRanks (an independent analyst tracking site) for his articles on Seeking Alpha.