Introduction
In recent times, whenever the economic conditions start deteriorating, or the stock market becomes volatile, investors have been seen flocking to alternative investments because of their potential to generate absolute returns and being mostly uncorrelated to equity markets. While there is no guarantee of positive or above-market return on any investment, alternative investments offer many potential benefits that make them attractive to both individual and institutional investors. An alternative investment, basically, is an investment in an asset or fund that does not fall into one of the conventional equities, fixed-income, or cash categories.
Because of their complex nature, high investment minimums and relatively lesser regulation, most alternative investments or “Alts” have traditionally been an investment playing field for institutional investors and accredited, high-net-worth individuals. The 2008 economic downturn was a wake-up call for many investors. For years, the traditional investment world had been telling people that the only way to make money was to invest in stocks, bonds, and mutual funds. But when the economy tanked, those investments went right down the drain. Now, thanks to market changes, new and modified regulations, and product innovation, the mass affluent crowd is finally getting exposure to alternative investments. And it’s about time.
Because alternative investments are not as well known or understood by the average investor, they have been largely off-limits. But that’s changing. Thanks to the new regulations, investors can now get exposure to alternative investments even through products like exchange-traded funds (ETFs) and mutual funds. And a growing number of products and strategies are getting designed every day for the mass affluent individual investors.
A large number of millennials and Gen Zs with sufficient disposable incomes have also started allocating a substantial portion of their portfolios towards alternative investments. One can attribute many factors to this shift in asset allocation preference among these individual investors. Among them is the potential of alternatives to generate absolute / uncorrelated returns, the investment minimums coming down and the emergence of new-age alternatives like cryptocurrencies and fractionalization of assets. This list of factors can also include the arrival of funds that primarily invest in alternative assets. These alternative investment funds have made it much simpler today to invest in alternatives, especially for those who wouldn’t have had this opportunity a few years back.
Unlike traditional assets or funds, alternative investment funds are usually not constrained by regulations to invest only in stocks or bonds, or stick to a fixed strategy like long-only. This freedom allows alternative investment funds to invest across multiple assets and employ a broader range of investment strategies, providing investors with greater diversification and potential for higher returns. Although the alternative investments universe can include a wide array of assets and funds, this article focuses only on the most common alternative investments. To learn more about the non-traditional, emerging, or esoteric alternative investments, one can read: The New-Age, Emerging, and Esoteric Alternative Investments Investors Must Know About
Real Estate / Managed Real Estate
Real estate has been one of the most popular investment options for centuries, and for good reasons. It is a tangible asset that can appreciate in value over time, and it can also generate rental income. Unlike stocks and bonds, real estate is not subject to the same volatility, making it an appealing investment for risk-averse investors.
When it comes to real estate investment, there are a number of ways to skin the proverbial cat. Today, investors who don’t want to be property owners have multiple options to invest in professionally managed real estate, including REITs, crowdfunded real estate platforms and fractional ownership. These financial instruments can provide many of the same benefits of traditional real estate ownership without the hassle and responsibility of being a landlord. REITs, or real estate investment trusts, are corporations that own or finance income-producing real estate. REITs can be publicly traded on major stock exchanges, or they can be private.
Crowdfunded real estate platforms are also a great way to get exposure to a variety of different types of real estate. One can invest in commercial, residential, farmland, and more. These platforms allow investors to pool their money with other investors to get a piece of the pie. One of the great things about crowdfunded real estate platforms is that they do all the legwork. They research properties, vet the investment, and handle all the paperwork. This makes it a great way to invest in real estate without having to do a lot of work from an investor’s point of view.
Fractional ownership is another way to invest in real estate without taking on the responsibilities of ownership. With fractional ownership, a group of investors owns a property together. Each investor owns a “share” of the property and is responsible for a proportionate share of the costs and responsibilities associated with ownership.
Both REITs and fractional ownership offer a number of benefits to investors. The foremost among them is they provide a steady stream of income. This is especially true for REITs, which in the United States are legally bound to distribute at least 90% of their taxable income to shareholders.
Liquid Alternatives
A liquid alternative investment is an investment that typically provides exposure to an asset class or strategy that is not available through traditional investment vehicles. For example, one cannot invest in hedge funds and private equity typically through conventional mutual funds or exchange-traded funds (ETFs). However, multiple publicly traded funds and ETFs today have made investing in strategies employed by hedge funds and private equity accessible to ordinary investors.
The most common liquid alternative investment strategies include long-short equity, market-neutral, managed futures, and multi-alternatives. Long-short equity funds take both long and short positions in stocks, betting that some will go up in value while others decline. Market-neutral funds attempt to achieve returns that are not correlated with the stock market by investing in both long and short positions. Managed futures funds invest in futures contracts, which are agreements to buy or sell an underlying asset at a later date. Multialternative funds invest in a combination of stocks, bonds, commodities, and alternatives.
Liquid alternative funds can provide investors with several benefits. First, these funds can offer higher potential returns than traditional stock and bond funds. Second, they can help investors to diversify their portfolios, as they are not as closely tied to the stock market. Third, they can provide downside protection in a bear market.
Hedge Funds
A hedge fund is an investment fund that pools capital generally from accredited or institutional investors and invests in various assets, often using complex investment strategies. Hedge funds are usually less regulated, which allows them to use aggressive investment strategies that may be too risky for traditional regulated investment vehicles.
The term “hedge fund” originally referred to a type of investment fund that hedged against the risk of a declining stock market by short-selling stocks. However, hedge funds today engage in a wide variety of investment strategies, and the term is used more broadly to refer to any type of investment fund that employs high-risk, high-reward investing strategies.
Hedge funds are often compared to private equity and venture capital funds, but there are important distinctions. Hedge funds typically have a shorter investment horizon and seek to generate absolute, rather than relative, returns. Private equity and venture capital funds, on the other hand, typically have a longer investment horizon and seek to generate returns by investing in companies and taking them public or selling them to a larger company.
The history of hedge funds can be traced back to the early 1950s when hedge fund pioneers such as Alfred Winslow Jones and George Soros began employing innovative investment strategies. However, it was not until the 1970s and 1980s that hedge funds truly began to take off, as more and more investors became interested in these high-risk, high-reward investment vehicles.
Today, there are thousands of hedge funds with billions of dollars in assets under management. Hedge funds have become an important part of the global financial system, and their impact – activism, ESG, block deals, volatility and others – can be felt everywhere.
Commodities And Commodity Trading Advisors (CTAs)
Commodities have been used as an investment for centuries, but only in the 1970s, during the high inflation era, they started gaining popularity as an alternative investment class in the US. Commodities are physical goods that are used in the production of other goods or services. They include agricultural products, such as wheat and corn, and minerals, such as gold and oil.
Commodities are considered an attractive alternative investment for several reasons. First, they offer the potential for high returns. Second, they act as a hedge against inflation. When the prices of other investments, such as stocks and bonds, go down, the prices of commodities tend to go up. This makes commodities a good investment to protect one’s portfolio from inflation. Third, commodities sometimes also act as a hedge against geopolitical risk. For example, whenever there is a war in the Middle East, oil prices usually go up. This is because the demand for oil remains the same or goes up while the supply declines. Commodities also offer the benefits of diversification to investors, making it the fourth reason they are considered an attractive alternative investment.
The most popular way to invest in commodities has been through commodity futures contracts. A commodity future is a contract to buy or sell a specific amount of a commodity at a specific price on a specific date in the future. Commodity futures are traded on exchanges, such as the Chicago Mercantile Exchange. Another popular way to invest in commodities is through commodity-indexed mutual funds. These funds invest in a basket of commodities based on a methodology or track the performance of known commodity indices like the S&P GSCI Commodity Index.
Commodity trading advisors (CTAs) are professional money managers who trade commodities. CTAs use technical analysis to make trading decisions. For those who might not know, technical analysis is a method of predicting future prices based on past price movements. CTAs manage commodity pools. A commodity pool is an investment vehicle that pools the money of many investors and invests it in commodities. Commodity pools are similar to mutual funds but are not regulated by the U.S. Securities and Exchange Commission (SEC). A CTA manages the commodity pool and makes all of the trading decisions.
Private Equity
For many years, private equity has been an attractive alternative investment option for those looking to get involved in the ownership of companies that are not publicly traded. Privately held companies are not subject to the same public disclosure and regulatory requirements as publicly traded companies, which many investors feel acts as an impediment to the growth of public companies. Private equity firms typically use leverage to finance their investments, which can help increase returns. Leverage, however, also magnifies risks, which is why private equity is considered a higher-risk investment than other asset classes. Many private equity firms acquire publicly traded companies through a leveraged buyout (LBO) – a type of transaction in which a company is purchased with a high amount of debt financing – aiming to improve the company’s financial performance and eventually sell it for a profit.
The private equity industry has its roots in the early days of capitalism, when wealthy individuals would finance young businesses in exchange for a stake in the company. In the 1970s, private equity firms began to emerge as a distinct asset class. One of the earliest and most successful private equity firms in the world currently is Kohlberg Kravis Roberts (KKR), which was founded in 1976.
The late 1980s saw the rise of the “mega-funds,” i.e. private equity firms with billions of dollars in capital and access to more capital through debt financing. These firms used their huge war chests to engage in large LBOs, such as the $25 billion buyout of RJR Nabisco in 1988.
The late 2000s were marked by a number of high-profile failures in the private equity industry amidst the 2008 financial crisis, which also saw the collapse of Lehman Brothers. Despite these setbacks, private equity has remained among the most popular alternative investment options for many investors.
Venture capital is a sub-category of private equity that includes investments in early-stage companies. Venture capitalists are typically interested in companies with high growth potential, such as technology or biotechnology and provide financing in exchange for an equity stake in the company. Some venture capital funds also provide guidance and assistance to the company’s management team.
The modern venture capital industry emerged in the postwar era, with the founding of firms such as American Research and Development Corporation (ARDC) in 1946. ARDC was the first venture capital firm to use the limited partnership structure, which is still used by many venture capital firms today.
The 1960s and 1970s saw the rise of the “venture capital cycle,” in which venture-backed companies would go public and generate large returns for investors, and then the cycle would turn. One of the instances when this venture capital cycle hit its lows, was in the late 1980s when several venture-backed companies failed, and several venture capital firms started reporting losses.
The 1990s were a period of renewed growth for the venture capital industry, as the Dot-com boom generated a number of successful new companies, such as Google and Amazon. However, the early 2000s saw a number of high-profile failures in the venture capital industry after the Dot-com bubble burst. Nonetheless, the last decade again brought venture capital to the forefront of the alternative investment universe. Today almost all successful startups one hears about have been funded at different stages by one or more venture capital funds such as Sequoia Capital and Andreessen Horowitz.