Building your wealth
Alternative investments are exotic assets that can diversify your portfolio
If you were sorting broad investment concepts and assets into buckets, you'd need four: One for cash, one for stocks, one for bonds, and one for — everything else. That fourth bucket could also rightly be labeled "alternative investments," and its contents, while slightly more opaque than those of its fellows', have a lot to offer the savvy investor.
Although the financial barriers to entry can often be quite high, alternative investments provide unparalleled portfolio diversification. They offer exposure in arenas like real estate, the commodities market, even the art world — all of which can serve as a hedge when assets like stocks and bonds and the rest of the financial markets are suffering.
Alternative investments also go largely unregulated, however. So it's important to be informed on the risks as well as the rewards before wading in.
Because the term is so all-encompassing, it's often easier to define alternative assets by what they're not rather than what they are.
The group includes any asset that doesn't fit into one of the conventional categories, known as traditional investments, touched on above: cash, stocks, and bonds, as well as the mutual or exchange-traded funds (ETFs) that hold them.
It could be a physical item like a valuable bottle of wine, a piece of art, or an office building. Or something more intangible, like a derivative or an ownership stake in a private business.
What alternative investments all have in common, however, and in contrast with traditional investments, is that most of them aren't regulated by the United States Securities and Exchange Commission (SEC).
Whereas traditional investments are governed by strict disclosure regulations and protections against fraud, alternative investments put the onus on the investor. If you purchase a piece of art, for example, and then determine that it's a forgery but can't track down the seller, that loss is yours to swallow.
For those reasons, as well as the high investment minimums that often accompany them, alternative investments have traditionally been most popular with institutional and accredited investors — those with extensive capital and income, plus experience in dealing with complex financial assets.
But as alternative investments move within reach of the average investor, often via mutual funds that invest in them, a basic understanding of the major categories and their features is becoming increasingly important.
Here's a rundown of the five major classes of alternative investments and what investors need to know about them.
What they are: Commodities are physical material and natural resources that are traded on the market. We're talking items like grains, oil, gold, beef, and natural gas, which you can either be directly in possession of, or own shares in.
How they work: When paper assets (the stock and bond markets) move one way, commodities tend to move the other, making them a popular hedge against inflation. For example, many experts recommend investing 5-10% of your portfolio in gold, because when the market suffers, its price soars, providing a cushion against loss.
If you're invested in shares of a given commodity, you'll receive dividends when it spikes in price. But if you own the item itself — considered by some to be a purer form of investing — you can profit only at its sale.
What to know: Because the prices of commodities are driven by supply and demand, they can prove quite volatile. Experienced traders often buy and sell commodity futures contracts (an agreement to buy or sell at a certain price within a set window of time) instead of shares in the commodity itself. In essence, it's betting on which direction the price will move and making money off of correct guesses. But if you're new to investing, it's quite a complex way to jump in.
Instead of stumbling straight into these assets, look for a stock that tracks or reflects the commodity you're interested in. Shares in gold-mining companies, for example, are much easier to buy than the actual yellow metal, but they often move in tandem with it.
What they are: The options for what can be a collectible are virtually endless — people will treasure, seek out, and stockpile just about anything. But in general, they're tangible items in your personal possession that you enjoy, but also hope will appreciate in value over time.
That could be anything from A(ntique jewelry) to Z(ebra-patterned rugs). The most commonly recognized include works of fine or decorative art (including jewelry), numismatic coins or stamps, vintage cars, and other vehicles, rare books, and fine wines.
How they work: The collectible's value comes from its age and rarity, the completeness of a collection, or the care that's been taken to preserve the item in its original state. But no matter the object or its condition, there's no way to directly make money from it until the point of sale — although you might be able to use it as collateral to borrow or raise money.
But by and large, your ability to profit depends upon your ability to find a buyer who values the items at the same level you do. And therein lies a problem.
What to know: Because collectibles aren't traded on any public exchange, there's no transparency to pricing — no official mechanism to determine market worth. In fact, aside from auction results, there are no published prices at all; many dealers keep sales confidential, in fact.
That means there's often no data-driven way to determine which items will appreciate over time, and which will depreciate. Different types of collectibles go in and out of fashion. So try not to get caught up in crazes, which are rarely sustainable over long periods — Beanie Babies being a prime example.
Also, you need only turn on an episode of Antiques Roadshow to see how useful it is to consult with an expert when it comes to collectibles. No matter how treasured your possession, there's no guarantee that its sentimental value will translate to actual dollar signs. So make sure you know what you have, and try to get documentation to prove it. Both will prove invaluable when the time comes to find a buyer.
What it is: Potentially the most familiar of alternative investments, real estate is exactly what it sounds like: land or property held by someone for financial gain. That can mean anything from an apartment building to a shopping center, from farmland to a city plot.
The property can be intended solely for the purposes of increasing capital, like a house flip or a rental unit, but it doesn't have to be. If you own your residence, or even rent and sublet out portions of it, you're already a real estate investor, whether you realize it or not.
How it works: Real estate investments can produce a profit in three main ways: through rental income, an increase in property values, or more unusually, royalties for any discoveries made on your land, such as minerals or oil.
What to know: Collecting rent tends to be the most reliable and accessible of the three forms. Profits from selling the property are also common — though taking advantage of appreciation requires careful timing of the real estate market.
Property values can increase due to surrounding development, your own improvements, or the location increasing in desirability. But they can just as easily drop if trends go the other direction, leaving your property languishing on the market, or forcing you to take a loss. Oftentimes, it comes down to being in the right place at the right time — or vice versa, as the 2008 housing crisis taught us.
Be careful not to overextend yourself. If you're looking to diversify your portfolio without taking on a mortgage or becoming a landlord, there are alternatives to direct ownership. Instead, consider a real estate investment trust (REIT), a publicly traded — and hence, much more liquid way — to give yourself similar exposure to this asset group.
What it is: Private equity refers to capital that is shuttled into privately held companies or partnerships, either as an investment in their future success or as a reorganization tactic, with the aim of making changes and then reselling the company (or one's ownership stake) at a profit.
How it works: There are multiple times during the life of a given company when it could benefit from a cash infusion, and it's a goal of private equity firms to be present for those opportunities.
Chunks of the company can be purchased in its high-risk early stages (angel investing), to assist with expansion or restructuring (venture capital), or in a buyout at a more mature stage. After acquiring ownership, a firm will use its expertise to restructure or repackage the company or one of its branches, and then seek to recoup its investment, either by reselling its stake or taking the company public.
What to know: The opportunities aren't available to the average investor as they require an immense amount of capital: the minimum investment for a private equity firm is often $25 million, although it can go as "low" as $250,000.
That puts the instrument out of reach for most folks, although there are now options for more standard earners, like funds of funds — pooled funds which invest in hedge or mutual funds — and ETFs that track privately traded companies. Both of which have much lower minimum investment amounts. The world of crowdfunding has also dropped investment minimums in private deals.
What they are: Derivatives are contracts between two or more parties that's built on speculation about the changing value of an underlying asset — an option being one of the most common examples. They can be used for risk management, pure speculation, or leverage.
How they work: It's basically a way to lock in a price and position each party on either side of it; if your side of the pricing wins out, you make a profit. For example, if it's April and you're a farmer hoping to sell your wheat crop in October, you might purchase what's known as a futures contract to sell wheat at $5 a bushel. If the price of wheat goes up to $7 in October, you'd be wise to let that contract expire and sell at the new price. But if it dips down to $4, you could either use your contract or sell it for a tidy profit.
What to know: The above description is how derivatives were initially designed. But they rarely work that way anymore, with actual assets being bought and sold. Instead, they operate more speculatively. Instead of a farmer insulating his grain harvest and shoring up his income, they've become much more popular with traders hedging their portfolios.
This distancing makes derivatives sensitive to market sentiment, which often leads to movement unrelated to the actual price of the asset. This can inflate the price of a derivative when you're trying to buy, and tank it when you're trying to sell, making it surprisingly illiquid.
While alternative investments offer compelling pros — portfolio diversification, a counterbalance to traditional financial assets — they aren't without their drawbacks. Even when the buy-ins are within reach, the lack of both liquidity and transparency is a major risk.
Taking on one of the above investments means wading into strange, exotic waters made all the opaque by the lack of regulation and open pricing. In such seas, it's possible for the sophisticated investor to make money hand over fist, but it requires sharp senses, a strong stomach, and endless patience for all the tedious complexities that alternative investments have to offer.
Without those well-honed skills —and a heaping portion of luck — alternative investments might just be too high-risk for the novice investor. As an alternative (to the alternatives), consider getting your feet wet with publicly traded vehicles like individual stocks or funds that invest in the alternative asset classes.
It lets you keep one foot on the dry land of traditional investments — and often without committing quite so much money. If all goes well, there's plenty of time to move more directly into alternative investments down the line.
This article was written by Alexis Rhiannon from Business Insider and was legally licensed through the Industry Dive publisher network. Please direct all licensing questions to firstname.lastname@example.org.
The contents in this article are being provided for educational and informational purposes only. The information and comments are not the views or opinions of Union Bank, its subsidiaries or affiliates.
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