Table of Contents
- What Are Alternative Investments?
- Alternative Investment vs Traditional Investments
- 10 Types of Alternative Investments
- How Are Alternative Investments Structured?
- How to Invest in Alternative Investments
- Advantages and Disadvantages of Alternative Investments
- Things to Consider When Investing in Alts
Alternative investments can offer the upside of providing portfolio diversification for some investors because they’re not typically correlated with more traditional asset classes. These investments also have the potential to generate higher returns when compared to stocks and bonds, and some alternatives are structured to provide passive income to investors.
However, it’s also important to know that these investments tend to be illiquid (meaning it can be difficult to convert them into cash) and are higher risk in most cases — and may include the risk of total loss of the individual’s investment.
While alternative investments typically have been available to high net worth and accredited investors, these days retail investors can also gain access to alternative investments via certain types of funds focused on these strategies.
What Are Alternative Investments?
Alternative investments — commonly known as alts — are assets that fall outside conventional stock, bond, and cash categories. Alts used to be accessible mainly to high net-worth and accredited investors, but now they’re available to a range of investors, thanks to the emergence of vehicles such as mutual funds and ETFs that include various alternative assets.
Alternative investments may provide investors with portfolio diversification due to their lower correlation to traditional asset classes. Alts typically move independently of conventional stock or bond markets.
Alts include a wide variety of securities as well as tangible assets such as commodities, foreign currencies, derivative contracts, real estate, venture capital, art and antiques, memorabilia, and more (see below for a detailed list).
The name “alternative” does not imply these investments are new or live on the fringes of the financial world as compared with more traditional investments. They can be considered literally as alternatives to, or supplemental to, conventional strategies like stocks and bonds.
Understanding Alternative Investments
Many investors seek alternative investments because they are not typically correlated with conventional markets. Thus, investing in alternative assets may provide portfolio diversification, potentially reducing the risk of loss during a market downturn, and possibly adding to long-term gains.
Alternative investments also have the potential to generate higher returns compared to traditional assets, although this also comes with greater exposure to risk. Alts, and funds that focus on alternative investments, may also be structured to pay out regular dividends so that investors can earn passive income.
Some alts can be compelling for investors if they believe that the assets may grow in value over time. But the lack of liquidity for most alts means that determining the fair market value of these assets can be quite challenging. Often there is little by way of public data available regarding price changes or asset appreciation or depreciation, making it difficult to assess historical performance.
In addition, the market for certain types of alternative investments can be highly changeable, with one type of asset gaining favor (and value) at one point, only to lose value when it falls out of favor.
For example, an original baseball card signed by a prominent sports figure might be more valuable, in theory, compared with 100 shares of a prominent U.S. company. But it is generally easier to sell shares of stock for a known price than to sell a collectible for an expected price.
Similarly, even if an alternative asset like a collectible or real estate is worth more at point A, an investor must bear in mind that its value could depreciate swiftly if market, climate, or political conditions change.
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Key Characteristics of Alternative Investments
Alternative investments can be quite different from each other, but they share a few key characteristics in common.
• Alternative assets may provide portfolio diversification because they have a low correlation to most other traditional asset classes.
• Alts may provide a hedge against inflation or interest rate fluctuations.
• Alts may provide the potential for higher returns compared to conventional assets.
• Most alts are illiquid, especially when compared with conventional securities, and may come with redemption restrictions.
• Owing to the lack of transparency and public data regarding performance, determining the real-world value of alternative investments may be difficult.
• High net-worth and accredited investors may find some alternative investments more accessible than retail investors.
Retail investors may be able to access some types of alternatives through mutual funds or ETFs that focus on these assets.
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Alternative Investment vs Traditional Investments
To recap: Traditional publicly traded investments generally include stocks, bonds, cash, and cash equivalents (i.e., money market funds). Traditional assets are typically liquid, highly regulated, and accessible for retail investors via taxable brokerage accounts or retirement accounts.
Alternative investments are non-conventional assets that may provide diversification because they don’t move in tandem with conventional markets, which can help mitigate certain risk factors. As a result, alts may offer the potential for higher risk-adjusted returns, and in addition, some alternatives may provide passive income. However, alternative investments also tend to be illiquid and higher risk than traditional assets.
While historically only accessible to high-net-worth and accredited investors, alts are becoming increasingly available to average investors through investment structures, such as mutual funds and ETFs.
10 Types of Alternative Investments
The following list encompasses some common types of alternative investments available today.
• Summary: Individuals can invest in natural resources, including agriculture, metals (e.g. precious metals such as gold, silver, and platinum), energy (including renewables), and other raw materials. Generally, investors participate in commodity trading using futures contracts, index funds, or ETFs.
• Pros and cons: Some investors consider commodities a good hedge against inflation, and under the right conditions there is the potential to see a profit. However, commodities can suffer from any number of unexpected risk factors, from weather conditions to supply chain dysfunction and more.
• Summary: Currencies are an example of an alternative investment that can be highly liquid, and thus easier to trade.
• Pros and cons: Currency trading is known for its volatility, and currency traders often make leveraged trades, assuming a high degree of risk. Retail investors may find it potentially less risky to invest via mutual funds, ETFs, foreign bond funds, and even certain types of CDs (certificates of deposit), although the underlying volatility of most currencies will influence the performance of these vehicles as well.
• Summary: Like any real estate, farmland and timberland tends to increase in value over time. Also, this type of land can be similar to commodities in that there is potential profit in the products that come from the land (e.g. produce and timber).
• Pros and cons: Owners of farmland can lease out the land to earn income, which can also be profitable for investors. The downside of investing in farmland and timberland are the environmental and weather-related risks that can impact both the value of the land and the productivity.
• Summary: Infrastructure refers to the physical structures that economies depend on: roads and highways, bridges and tunnels, sewage treatment, energy pipelines, and more. Municipal bonds are one way to invest in infrastructure, as are some types of REITs (real-estate investment trusts).
• Pros and cons: As a non-cyclical type of asset, infrastructure investments may offer the benefit of less exposure to market risk factors, steady cash flows, and low variable costs. The risks of infrastructure investments include political and environmental factors that can impact or delay the execution of a project.
5. Private Equity
• Summary: Private equity investing has its roots in stock investing, in that individuals can invest money in certain companies and startups directly. But private equity shares are not traded on public exchanges.
• Pros and cons: Private equity is considered a high-risk investment, but if a private company goes public or gets acquired, these investments may perform well. The risk with private equity investments is that these are often focused on distressed companies, with a complex track record, and sometimes startups (see Venture Capital below).
6. Venture Capital
• Summary: VC investing is a way of putting money into startups, though there is no guarantee of a return. 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.
• Pros and cons: Venture capital investing is considered a subset of Private Equity, as noted above. It can be risky because if the startup fails, investors may lose all of their money. On the other hand, if a startup does well, investors may see significant gains.
7. Private Credit
• Summary: Private credit refers to direct loans to companies that offer a higher yield than traditional fixed income. It used to be the purview of institutional investors. Now it’s possible to invest in private credit funds, assuming an investor meets the higher minimum investment requirements.
• Pros and cons: Private credit funds tend to see greater inflows when the stock market is underperforming, and they pay higher rates than conventional fixed income instruments. The risk here is that most PC funds offer only quarterly redemptions — so they’re quite illiquid — and they can be vulnerable to defaults.
8. Real Estate
• Summary: Real estate is one of the oldest asset classes. You can invest in real estate by owning a rental property, investing in commercial real estate, industrial real estate, or other options. Investors can also buy into Real Estate Investment Trusts, or REITs.
• Pros and cons: Investing in real estate requires some knowledge, skill, and luck. And though real estate tends to hold its value over time, different properties can be vulnerable to a host of factors including ownership and business trends, land values, interest rate risk, and more.
9. Art & Antiques
• Summary: Any investor with a passion for art may acquire pieces they believe will grow in value over time. It’s also possible to invest in fractional shares of art, or in shares of an art-focused fund.
• Pros and cons: Investing in art or antiques may provide a hedge against inflation or other market factors, especially when investing over time. That said, investing in art via direct acquisition is typically more accessible for high net-worth individuals. The cost of upkeep over time is another factor. And while some pieces may gain value over time, art and antiques can also be subject to fraud, as well as changing trends and tastes.
• Summary: Collectible investments can double as hobbies, and may include coins, rare books, baseball cards, comic books, toys, or other items that are available in limited quantities.
• Pros and cons: It’s almost impossible to predict which collectibles will retain their value and which will lose value over time. Paying a certain amount for a vintage car, book, toy, or celebrity autograph has no bearing on what the item may be worth when you try to sell it.
💡 Quick Tip: Distributing your money across a range of assets — also known as diversification — can be beneficial for long-term investors. When you put your eggs in many baskets, it may be beneficial if a single asset class goes down.
How Are Alternative Investments Structured?
While often available in less conventional investment vehicles, alternative investments are also available through traditional financial structures that may be accessible to any investor. Here are some of the different ways alternative investments may be structured.
An exchange-traded fund or ETF is an investment vehicle that enables investors to buy a group of stocks, bonds, commodities, or other securities in one bundle, thus promoting investment diversification and efficiency. They’re widely available, usually through major investment fund companies.
These closed-end funds are not traded on the secondary market and have limitations on redemptions (among other risks and restrictions). But because the funds are highly illiquid and have infrequent redemptions, fund managers may use alternative investments to pursue higher yields.
A master limited partnership, or MLP, is a business partnership that’s publicly traded on an exchange. While an MLP may sound like a company, these partnerships have a different type of structure and are restricted to natural resources and energy-related products and sometimes real estate.
MLPs can provide the liquidity of stocks, but the tax treatment can be complex — and they are higher risk than regular equities.
A mutual fund is an investment vehicle that pools money from many investors in order to invest in different securities. Mutual funds may hold any combination of stocks, bonds, money market instruments, or cash and cash equivalents.
They may also include alternative investments, such as real estate, commodities, or investments in precious metals.
A real estate investment trust, or REIT, is a way of investing in shares of different types of real estate within a single fund. REITs invest in companies that own, operate, or finance a wide variety of real estate types.
How to Invest in Alternative Investments
If you’re thinking about adding alternative investments to your portfolio, it’s important to know that investing in alts isn’t the same as choosing, for example, a target date fund within your company’s 401(k) plan.
As mentioned above, alternative investments used to be limited to accredited and high net-worth investors, but they’re now available to average investors through mutual funds, ETFs, and sometimes even through companies’ IRAs.
Because it’s still relatively new for retail investors to have access to alternative assets, finding the right brokerage and/or asset manager can help you incorporate alts into your portfolio in the way that makes the most sense for your circumstances and your long-term plan. SoFi, for example, is working with knowledgeable asset managers in the alts space to provide access to mutual funds across a variety of categories.
Once you’ve identified the types of alternative assets that would suit your goals, your risk tolerance, and your plan (e.g., you might prefer commodities to owning art), you can look for the funds that would help you buy into these asset classes.
Advantages and Disadvantages of Alternative Investments
In sum, alternative investments may be worth considering, thanks to some of the advantages they offer. But it’s important to keep in mind the disadvantages, in order to make the best choices in light of your own goals and risk tolerance.
In short, the potential upside of alternatives includes:
• Alternative strategies offer the potential for higher risk-adjusted returns.
• Alternative investments are not typically correlated with traditional stock and bond markets, so they may help diversify a portfolio and mitigate risk.
• Some alts have the potential to deliver passive income.
• Some alternatives may provide tax advantages, such as special capital gains rates or the ability to defer taxes.
• Some alts may hedge against inflation or interest rate fluctuations.
• May appeal to an individual’s personal interests: e.g., art, wine, memorabilia.
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. Potential downsides of alts:
• Often limited to high net-worth and accredited investors.
• Often higher risk or can be subject to greater volatility.
• Can be less liquid than traditional investments due to limited availability of buyers and lack of a convenient market.
• May have high minimum investment requirements.
• May have high upfront investment fees.
• May have less available public data and transparency about performance, making it difficult to determine an asset’s value.
Things to Consider When Investing in Alts
Alternative investments are complex, and while the risk may be worth the potential reward in the eyes of some investors, there are some additional caveats to bear in mind about these assets.
How Are Alternative Investments Taxed?
Unlike conventional asset classes, which are typically subject to capital gains or ordinary income tax, different alts can receive very different tax treatments, even when investing in these assets via a mutual fund or ETF. When investing in alts, it’s wise to involve a professional to help address the tax-planning side of the equation.
What Role Should Alts Play in Your Portfolio?
When thinking about including alternative assets in your portfolio, you might consider a couple of key factors. Bearing in mind your current asset allocation, adding alternative strategies can enhance diversification as well as your portfolio’s overall growth potential.
Remember, because alts don’t generally move in sync with traditional asset classes, they may offset certain risk factors. And while alts come with risks of their own, including volatility and lack of transparency, within the context of your portfolio as a whole alts, and funds that invest in alts, may enhance returns. Some alternative assets can provide passive income as well as gains.
It’s important to know, however, that alternative investments are higher risk, tend to be more illiquid, and less transparent. Alternative investments should only be one part of your portfolio to complement other assets. Some advisors, for example, recommend up to a 10% allocation for alternative investments, though this number will vary depending on your circumstances, tolerance for risk, and long-term goals.
If you are risk-seeking and have ample liquidity with other investments, you can perhaps allocate more toward high-risk, high-return alternatives.
Alternative investments have the potential for high returns and may offer some portfolio diversification. The sheer scope and variety of these investments means investors can look for one (or more) that suits their investing style and financial goals. Unlike more conventional investments, alts tend to be higher risk, more expensive, and subject to complex tax treatment.
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 vehicles such as mutual funds and ETFs.
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Are ETFs considered alternative investments?
Generally no. For the most part, exchange-traded funds (ETFs) are passive investments — meaning they track an index — and typically that index is for a conventional asset class like stocks or bonds. That said, some ETFs track niche parts of the market, including certain types of alternative strategies, including options, long-short strategies, managed futures, real estate investment trusts (REITs), and more.
Are alternative investments worth it?
For some investors, choosing to add alts to their portfolio might be worth it because alternative assets can add diversification (which can help manage risk), and alts may enhance returns over time. But alts also come with their own set of risk factors, including the fact that some alternative assets are illiquid, and are not regulated like other financial products.
How do alternative investment funds work?
Alternative investment funds work in a range of ways. A mutual fund focused on alternative strategies, like derivatives, is likely to be actively managed and employ techniques like leverage or short selling. Before investing in an alternative fund, it’s wise to make sure you understand the underlying strategy, assets, and fees.
An investor should consider the investment objectives, risks, charges, and expenses of the Fund carefully before investing. This and other important information are contained in the Fund’s prospectus. For a current prospectus, please click the Prospectus link on the Fund’s respective page. The prospectus should be read carefully prior to investing.
Alternative investments, including funds that invest in alternative investments, are risky and may not be suitable for all investors. Alternative investments often employ leveraging and other speculative practices that increase an investor’s risk of loss to include complete loss of investment, often charge high fees, and can be highly illiquid and volatile. Alternative investments may lack diversification, involve complex tax structures and have delays in reporting important tax information. Registered and unregistered alternative investments are not subject to the same regulatory requirements as mutual funds.
Please note that Interval Funds are illiquid instruments, hence the ability to trade on your timeline may be restricted. Investors should review the fee schedule for Interval Funds via the prospectus.
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