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Alternative Investment Guide: Definition, Types, Pros & Cons

By Mike Zaccardi, CMT, CFA · June 17, 2022 · 12 minute read

We’re here to help! First and foremost, SoFi Learn strives to be a beneficial resource to you as you navigate your financial journey. Read more We develop content that covers a variety of financial topics. Sometimes, that content may include information about products, features, or services that SoFi does not provide. We aim to break down complicated concepts, loop you in on the latest trends, and keep you up-to-date on the stuff you can use to help get your money right. Read less

Alternative Investment Guide: Definition, Types, Pros & Cons

Traditional investments include publicly traded stocks, bonds, and cash–funds that include a mix of the three. These investments typically appear in your workplace 401(k) plan and are most common in the portfolios of retail investors. Alternative investments are other asset classes that may add diversity to a portfolio.

Common alternative investments include gold, art, and real estate, but there are many different other alternative investments. Many investors like alternative, or non-conventional, investments because they perform independently of the stock market, potentially boosting returns and reducing overall losses during a market downturn. That’s particularly attractive during times of high volatility in the stock and bond markets.

However alternative investments also tend to have less liquidity, since they don’t always trade on public markets, and they can carry other risks as well, such as valuation challenges or increased use of leverage. So they’re not always appropriate for beginner investors. Let’s look into some popular alternative investment options, their potential benefits and downsides.

What Are Alternative Investments?

Alternative investments are assets other than stocks and bonds investors believe offer higher potential returns and low correlation to traditional assets like stocks and bonds. Securities regulators consider some alternative assets, like hedge funds and private equity, risky, making those assets available only to high net-worth, accredited investors.

There are, however, plenty of alternative assets, such as real estate and commodities, available to retail investors.

What Are Alternative Funds?

Generally speaking, alternative funds for the average investor refer to mutual funds or exchange-traded funds (ETFs) that use nontraditional investments and trading strategies to help them meet their fund objectives.

Alternative funds might invest beyond core investments—including stocks, bonds, cash, and cash equivalents—to focus on alternative investments such as real estate, commodities, loans, and even unlisted securities.

Alternative Funds Strategies

Alternative funds typically use a broad range of complex investment strategies. Some funds will use one single strategy, such as investing entirely in currencies, for example.

Others may use multiple strategies, and still others may be what are known as “funds of funds.” These special alternative funds can hold multiple funds that use multiple strategies. Here’s a look at some of the strategies alternative funds might use:

Hedging

Hedging is strategy to help protect investments from the risk that they will lose value. Many investing strategies use derivatives, which get their value from underlying assets such as stocks or bonds. For example, an option is one of the most common types of derivative, and gives investors the right to buy or sell a stock at a set price within a given timeframe.

Leveraging

At its most basic definition, leverage means debt. A leveraged fund is one that uses debt to increase gains within a short period of time. Leveraging can be a risky strategy because the fund that is taking on the debt is beholden to its creditors should its investments fail.

Short selling

Short selling is an investment strategy that allows investors to profit from securities when their value falls. To carry out a short sale, an investor first borrows a security from someone who owns it. The investor sells the security, and hangs on to the cash they make from the sale. At that point, the investor hopes that the price of the stock will fall, at which point they can buy back the same stock for less than they sold it for. Then they can return the shares they borrowed and keep the money that’s left over as profit.

Market neutral strategy

The aim of market-neutral funds is to provide stable returns in various market conditions. The fund does this by balancing a mix of short and long positions regardless of whether the market is moving up or down. Going “long” on a stock simply refers to buying a stock with the expectation that its value will rise. As a result, these funds can help insulate investors from market swings.

Opportunistic strategy

Investment strategies that change with market conditions as various opportunities arise.

Alternative Investment Strategies

There are several ways that alternative investments can make money. Each alternative investment is different, so investors should consider what their goals are when choosing assets to buy. Alternative investments typically fall into one of three categories:

•   Income: Some alternative investments provide a steady source of income, such as a rental property or a franchise.

•   Growth: This type of investment appreciates in value over time. Growth investments include assets like art and wine.

•   Balance: Some investments provide a balance of growth and income, such as a rental property, which might offer cash flow (in rent payments) as well as capital appreciation.

25 Alternative Investment Ideas

The following is not a full list of alternative investment options, but it does cover many of the more common options.

1. Real Estate

Real estate is one of the oldest asset classes available to investors. Aside from owning your home, you can invest in real estate by owning a rental property, flipping a house, investing in commercial real estate, industrial real estate, or other options. Investors can also buy into Real Estate Investment Trusts, or REITs.

Investing in real estate requires some knowledge, skill, and luck, but this popular alternative investment generally does well in all economic cycles.

2. Precious Metals

Precious metals such as gold and silver are popular alternative investments. Some investors consider them a safe store of value and a good hedge against inflation.

Investors can get exposure to precious metals by buying them directly or through exchange-traded funds (ETFs) or mining stocks. Precious metals have high liquidity levels, but they can still be very volatile during stock market drops.

3. Commodities

Individuals can invest in natural resources, including agriculture, metal, and energy. This includes raw materials such as coffee, sugar, beef, and corn. Generally, investors participate in commodity trading using futures contracts or ETFs.

4. Oil and Gas Limited Partnerships (LPs)

Oil and gas companies need ongoing investment to continue operating. Investors can buy into oil and gas LPs for exploration, land development, income, services, and support. While often featuring high yields, these investments can have complicated tax impacts.

5. Equity Crowdfunding

Investors can buy a slice of startup companies through equity crowdfunding platforms. This differs from traditional crowdfunding in that investors actually own equity in the company. This is considered a risky investment, because if the startup fails, investors may lose all of their money. On the other hand, if a startup does well, investors can see significant gains.

6. Art

Investing in art has traditionally been something only available to high net worth individuals, but there are some new ways to buy into this market through shares and crowdfunding. Interested investors can also buy into index funds that track with the art market.

7. Wine

High-end wine is an investment because wineries only produce a limited number of bottles produced each year. As the years go by, the number of bottles of each particular type of wine decreases, making each bottle more valuable, as long as demand for it continues. Wine can also be a play on climate change in that growing conditions could be negatively impacted by shifts in temperature and precipitation patterns.

8. Private Equity / Angel Investing

Individuals can invest in private companies through angel investing or private equity. This may be done individually or through a private equity firm. This is considered a high-risk investment, but if a private company goes public or gets acquired, these investments can do quite well.

9. Cryptocurrencies

A newer addition to the list of alternative investments, cryptocurrency is becoming widely accepted as a potential growth asset. As the cryptocurrency market matures, and regulation improves, more mainstream institutions are adding crypto to their portfolios. For investors who don’t want diversification within their crypto investments, there are now cryptocurrency ETFs available.

For those concerned about the volatility of crypto, stablecoins may provide a more palatable way to get exposure. Many of the most popular stablecoins are pegged to the U.S. dollar and priced at a constant $1 per token. Interest rates can range from 4% to 9%. They are not FDIC insured nor should be considered as safe as short-term bonds.

10. Collectibles

Collectible investments include coins, Beanie Babies, baseball cards, comic books, and other items that are only available in limited quantities. Collectibles are only worth what someone else is willing to pay for them.

So although a particular baseball card or vintage toy in its original box technically might be worth a certain amount, an investor will only make money if they can find someone willing to pay. Most collectibles are too common to actually have much value, but they can be fun to have. You can even invest in virtual collectibles via non-fungible tokens (NFTs).

11. Burial Plots

People interested in an alternative to traditional real estate can buy and sell burial plots in cemeteries for a profit. Burial plot investors purchase plots directly from the cemetery, hold onto them, and then sell them later, potentially at a higher cost.

12. Hedge Funds

A hedge fund is a pooled investment fund that invests in a wide range of assets, from public companies to commodities futures. They tend to invest in riskier assets, and sometimes they sell short— actually betting against a company’s success — which can be risky.

Most hedge funds require investors to be accredited, while others are available to all investors. The funds available to non-accredited investors are called funds of funds, because they are funds of hedge funds. This is an indirect way to invest in hedge funds.

13. Distressed Debt

Investing in distressed debt means buying up a company’s debt and hoping that they will be able to pay it back. Investing in distressed debt financial instruments is extremely risky because the issuing companies are failing or near bankruptcy, so there is a lower likelihood that they will be able to pay it back. However, if they do, the returns are typically high. A similar strategy could be investing in ETFs that hold very high yield fixed income securities.

14. Structured Notes

Structured notes are popular in Europe and are gaining traction in the U.S. A structured note is issued by a financial institution, and it has both bond and derivative components. The goal of a structured note is to payout an amount based on market conditions. Essentially, you often give up some upside to protect against severe declines.

An investor or advisor can create a structured note by tailoring the maturity of the bond piece, choosing among underlying assets, aiming for a certain payoff, and deciding on the level of protection they want. Fees have come down in this area, but they can still be pricey. Also, the structured note is backed by the credit of the issuer, so there is default risk.

15. Tax Liens

When property owners can’t pay property taxes and default on their loans, some municipal governments sell their tax liens in auctions. This allows the municipalities to collect the taxes owed plus additional interest. Investors who purchase these tax liens get the right to collect payments on the liens. In some cases, if the property owner can not pay, the lienholder could end up owning the foreclosed home.

16. Income-Based Repayment (IBR) Plans

With IBR loans, accredited investors can invest in offerings that have payouts based on student loan debts being paid back. Sites offering these products analyze schools and historical default rates in an attempt to ensure a high repayment rate.

17. Mineral Rights

People who own properties with minerals on them can sell the rights to mine those minerals to mining companies. Minerals can include things like diamonds, coal, or oil. Investors can also buy mineral rights and turn them into an income source.

18. Farmland

Like any real estate, farmland tends to increase in value over time. Owners of farmland can also sharecrop or lease out the land to earn income. This tends to be a long-term investment.

19. Timberland

The value of trees typically rises over time, so investors can buy into timberland with the goal of earning a profit after the harvest of the trees. Timberland is a real asset, and it has historically produced returns above those in the stock market.

20. Equipment Leasing

This long-term investment allows investors to buy into funds that own equipment that gets leased out to companies. This could include medical supplies, construction vehicles, or other types of equipment.

21. Trade Finance

When companies ship materials and products across borders, they have to pay import and export fees on those goods. To finance these costs, companies take out loans or get private investment. Investors can help finance these trades and get paid back with interest.

22. Marine and Aviation Finance

It’s extremely expensive to build and purchase ships and planes, so companies take out loans or get private investment to finance these operations. This type of investment can be risky, since changes in tariffs or the global economy can affect the market, but there is also significant potential for gains.

23. Film

A risky but fun investment, films have the potential to make a lot of money if they do well, but countless factors go into making them a success. Without an in-depth knowledge of the industry, film investing is very challenging to get into, though there are hedge funds and private equity funds that invest in films.

24. Franchise

One way for investors to bring in steady income and make a profit from growth is by buying a franchise. A few well-known franchises are McDonald’s, Taco Bell, and Dunkin’ Donuts. Investors can buy one or more locations, giving them an instant business with brand recognition. These franchises can bring in income and also make money when they’re sold. However, investing in franchises is a lot of work and not a passive investment.

25. Intellectual Property

Intellectual property (IP) includes things like images, inventions, and names. IP has the potential to continue increasing in value forever, but it’s challenging to choose which IP you want to invest in. One method is seeking out the next big brand, which is known as brand investing.

Pros of Alternative Investments

There are many reasons investors might consider adding alternative investments to their portfolio. They may offer protection from the volatility of the stock market and potential for high returns. Below are some of the benefits of alternative investments.

•   Increased portfolio diversification

•   Reduced risk exposure to the stock market

•   Potential for higher-than-average returns (for example, top hedge funds aim for returns between 25-30 percent)

•   Some alternative can hedge against inflation and rising interest rates

•   May have lower transaction costs

•   Appeal to an individual’s personal areas of interest, such as art or wine

•   A portfolio that includes some alternatives you hand-pick can make it easier to stick to a long-term strategy versus a one-size-fits-all portfolio chosen for you by someone else. This notion is based on the behavioral bias known as the endowment effect, which states that people value items they own more than the same asset someone else owns.

Cons of Alternative Investments

Like any investment, alternative investments come with their share of downsides. It’s important for investors to do their due diligence when researching and considering alternative investments.

These are a few cons to consider:

•   Often limited to accredited investors (net worth of at least $1 million or an individual income of at least $200,000) and qualified purchasers allowed to invest in riskier securities that are not registered with financial regulators

•   Can be less liquid than traditional investments due to limited availability of buyers and lack of a convenient market. Sometimes investors must hold their money in the asset for five or more years.

•   May have high minimum investment requirements

•   May have high upfront investment fees

•   May have less available data and transparency about performance

•   Often higher risk or volatility

•   May lack a clear legal structure since they aren’t required to register with the SEC

•   It can be difficult to determine value if the asset is rare and has few transactions

•   Vulnerable to fraud and investment scams since they are unregulated

•   Alternative assets may have lower levels of accessibility, since you may not find them in a 401(k) or traditional IRA account.

How Much Should Go Toward Alternative Investments?

It is really up to each individual to decide how much they want to allocate to alternative investments. Since alternative assets tend to be riskier investments, you may want to limit the total portion of your portfolio that you invest into any alternative asset class.

You must weigh your risk and return objectives as well as how much liquidity you desire. If you are willing to give up your money for many years, you might be able to capture what’s called the “illiquidity premium,” which is additional return due to the inability to convert the investment into cash. If you are risk-seeking and have ample liquidity with other investments, you can perhaps allocated more toward high-risk, high-return alternatives.

Alternative Investment Comparisons

Alternative Investments vs Traditional Investments

Alternative investments have important differences from traditional investments, but there are similarities, too. Traditional investments include positions in stocks, bonds, cash, and diversified funds. Alternatives, by contrast, commonly include real estate, commodities, private equity, and hedge funds. Cryptocurrency and non-fungible tokens are among the newer types of “alts” you can find.

Alternative investments usually exhibit lower liquidity versus stocks and bonds, less regulation, lower transparency, higher fees, and complicated tax impacts. They may also have limited historical performance for you to review.

Alternative assets have appeal as investment opportunities because they may help further diversify a portfolio of stocks and bonds, while also potentially increase returns.

Alternative Funds vs Hedge Funds

Investors may see alternative mutual funds and hedge funds discussed in the same breath, but there are some key differences between the two. Chief among them: The Investment Company Act of 1940 limits the operations of alternative mutual funds. These rules do not apply to unregistered hedge funds.

Protections under this act include limits on leverage and illiquid investments, diversification requirements, daily pricing, and rules governing the redeemability of fund shares. These regulars act as safeguards that protect consumers. Hedge funds are not subject to these limitations so they are free to pursue strategies not limited by the same regulations.

What’s more, hedge fund advisors are allowed to charge investors a “2/20” performance fee for advising the fund. This fee structure refers to a 2% annual management fee charged by the company for managing the assets and a 20% performance incentive fee charged against any profit made above a certain level. Alternative mutual funds and ETFs are not allowed to charge investors this kind of fee.

The Takeaway

Alternative investments have the potential for high returns and are a good way to diversify your portfolio and reduce risk. The sheer scope and variety of these investments means investors can look for one (or more) that suits their investing style and financial goals.

The first step for any investor who plans to add alternative investments to their portfolio is deciding which ones are of personal interest, and compliment their risk tolerance and investing goals. It’s important to research and do due diligence on any alternative investment option in order to make the best purchasing decisions and reduce risk. While some alternative investments are less accessible, others can be purchased through funds and ETFs.

One way to start investing in alternative investments is by using an online platform like the SoFi Invest® online brokerage. The trading platform lets members research and track their favorite stocks and assets, and build their portfolio right from their phone — buying and selling stocks, ETFs, cryptocurrencies, and more with a few clicks.

Ready to learn more about investing with SoFi Invest?


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