Investors are increasingly interested in alternative investments when looking to diversify their portfolios more broadly. Along with the growing popularity of these types of assets, there’s an expanded universe of choices within the alternatives category.
Alternatives tend to be more complex investments and can, in many cases, move counter to stock or bond markets, which may make them an effective portfolio diversification tool. There are a wide variety of alternative investment strategies, though the most common vehicles are private market investments and hedge funds.
The evolution of the alternative investment category has improved individual investor access. Alternatives may be a worthy consideration to fill out your portfolio. As you assess your options, it can be helpful to understand more about what they are and how they work.
At its most basic, an alternative investment is one that does not fall into a conventional investment category, such as stocks, bonds or cash.
Alternative investments originally grew due to the interest of large institutional investors such as managers of pension funds, endowment funds and foundations. “Institutions looked to benefit from both return enhancement and the non-correlation of returns to those of traditional investments,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management.
A key distinguishing feature of alternative investments is they’re often expected to generate an absolute return, independent of any benchmark.1 In other words, the performance of an alternative is not measured against another category of investments but is measured on its own performance in a given time period.
Another notable factor is that alternatives are actively-managed funds overseen by professionals with a unique skill set. “Alternatives often involve complex trading strategies,” says Chad Burlingame, director of alternative investments at U.S. Bank Wealth Management. “This is in contrast to the overwhelming trend in more conventional types of investments, where passive management vehicles such as index funds have become popular.”
Alternative investments can sometimes carry higher risk due to the types of investments included in their portfolios. However, as an investment category, alternatives have proven beneficial to many individual and institutional investors.
As stated previously, traditional investments tend to include stocks, bonds, and cash. Alternatives include a wide range of other investments, among them private equity, private debt and hedge funds. In comparing alternatives to traditional investments, here are some of the major distinguishing factors:
The primary potential benefit of including alternatives is to create a more broadly diversified portfolio. Because many alternatives have the potential to generate returns that aren’t correlated with traditional investments, it creates an opportunity for smoother portfolio performance over time.
The potential for return enhancement is also a reason to consider these non-traditional investments. “Private market equity and debt portfolios may be the best opportunities for investors to capture returns that aren’t readily available in traditional investments,” says Haworth. “It adds another tool to the investor’s toolbox.”
There are several different types of alternative investments. Here are two of the most popular:
1. Private market investments
Consider private markets as the alternative investing counterpart of publicly traded stocks. Unlike stocks and bonds, however, when a business seeks private investors, only accredited or qualified individuals may invest. Successful private market investments have historically shown the ability to outperform their public market proxies.2 There are three broad categories of private market investments:
Typically, seeking a worthwhile investment in this area requires familiarity with a given sector. You may want to consider tapping into a network of investors and advisors to help source solid private market opportunities.
2. Hedge funds
Hedge funds are investments that use pooled funds with the goal of achieving significant return potential. Hedge funds mostly consist of stocks and bonds, in addition to currency and futures markets. They often use shortening strategies and leverage to enhance returns or manage risk.
Because of the inherent risk associated with hedge funds, most are only appropriate for accredited/qualified investors. Investors must have the ability to withstand the total loss of value of their investment.
Among the different hedge fund strategies are:
Get more details on how hedge funds work to diversify your portfolio.
If you meet qualification requirements to include alternative investments in your portfolio, there are additional issues to consider to determine whether they’re an appropriate fit. These include:
Alternative investments are not a “do-it-yourself” investment option. “The support of a financial professional is vital to gain access to this part of the market,” says Haworth. “You need to think through the complexities and costs and determine which types of alternatives are most suitable for your circumstances.”
Talk with your financial advisor to find out more about how alternative investments may be a consideration as you seek to meet your long-term investment objectives.
Diversification and asset allocation do not guarantee returns or protect against losses.
Alternative investments very often use speculative investment and trading strategies. There is no guarantee that the investment program will be successful. Alternative investments are designed only for investors who are able to tolerate the full loss of an investment. These products are not suitable for every investor even if the investor does meet the financial requirements. It is important to consult with your investment professional to determine how these investments might fit your asset allocation, risk profile and tax situation. Hedge funds are speculative and involve a high degree of risk. An investment in a hedge fund involves a substantially more complicated set of risk factors than traditional investments in stocks or bonds, including the risks of using derivatives, leverage and short sales, which can magnify potential losses or gains. Restrictions exist on the ability to redeem or transfer interests in a fund. Private equity investments provide investors and funds the potential to invest directly into private companies or participate in buyouts of public companies that result in a delisting of the public equity. Investors considering an investment in private equity must be fully aware that these investments are illiquid by nature, typically represent a long-term binding commitment and are not readily marketable.
Accredited investor: For individuals, the requirement is generally met by a net worth that exceeds $1 million (excluding primary residence and any related indebtedness), income in excess of $200,000 (individually)/$300,00 (jointly with spouse) in the two most recent years with an expectation of the same in the current year, or individual has a Series 7, 65 and/or 82 securities license(s). (Relying on joint net worth or income does not mean securities must be jointly purchased.) For entities (including trusts, non-profit corporations exempt under s. 501(c)(3), LLCs, LLPs, corporations, etc.), the requirement is generally met with if the entity has assets in excess of $5 million (assuming the entity was not formed for the specific purpose of acquiring the securities offered), or when all of the entity owners are accredited investors. Please refer to Rule 501 under the Securities Act of 1933 for the complete definition.
Qualified Client: The requirement is generally met if the investor has at least $1M under investment with the fund manager, the investor has a net worth of more than $2.1 million (excluding primary residence and any related indebtedness), or the investor is a Qualified Purchaser (see below). Please refer to Rule 205-3 under the Investment Advisers Act of 1940 for the complete definition.
Qualified Purchaser: For individuals, the requirement is generally met when the investor owns (individually or jointly) $5 million or more in investments. [Relying on joint ownership of investments does not mean securities must be jointly purchased.] For entities (including trusts), the requirement is generally met if the entity owns $25 million or more in investments; the entity owns $5M or more in investments AND it is owned by two or more natural persons who are related as siblings/spouse; or all beneficial owners of the entity are each Qualified Purchasers. Please refer to Section 2(a)(51) of the Investment Company Act of 1940 for the complete definition.
1 “Absolute Return.” Investopedia. April 26, 2021.
2 “Everyone now believes that private markets are better than public ones,” The Economist, January 30, 2020.