Financial IQ

Exploring alternative investments

Alternative investments may help diversify your portfolio and potentially hedge against market uncertainty.

You may know diversification is one way to weather periods of market uncertainty. During particularly volatile or low-yield times, your investment strategy may benefit from more complex investments with returns that are separate from equity or fixed income markets.

That’s when you may want to consider alternative investments. Alternative investments tend to move counter to stock and bond markets, which may make them an effective diversification tool.¹

What is an alternative investment?

Before diving into specific types of alternative investments, it’s important to know what distinguishes them as an investment.

According to Kurt Silberstein, managing director, alternative investments at U.S. Bank Wealth Management, alternative investments differ from traditional stock and bond investing in that they’re:

Less regulated: Alternative investments are not subject to the same level of regulatory scrutiny when compared to investments such as mutual funds. Due to less regulatory oversight and the potential for higher risk, most alternative investments are only available to investors deemed as “accredited” or “qualified purchasers.” Each requires an annual income over a specific threshold over multiple years and/or a net worth over a specified level. Additionally, these products are not suitable for every investor even if the investor does meet the financial requirements.
Illiquid: Alternative investments such as private capital funds require a longer commitment or holding period. Private capital investments often require seven-to-10-year commitments. There is no secondary market for these investments. Hedge funds often restrict investors from redeeming their money after the initial investment and in limited circumstances, may provide opportunities for redemption but at discounted prices.
Use more leverage than traditional investments: Alternative investments often utilize borrowed capital (leverage) in an attempt to enhance the return, which can magnify potential losses or gains and involves a heightened category of risk for investors.

A key distinguishing feature of alternative investments is they’re expected to generate an absolute return, independent of any benchmark.² “If you look at a relative return investment, such as stocks and bonds,” explains Silberstein, “you’re comparing it to a publicly traded index such as the S&P 500. It’s considered a success if your investment outperforms the index, even if your return is negative.”

For example, let’s say the S&P 500 returns -4.4 percent (like it did in 2018) and your investment returns -3.5 percent. Although your investment lost money, comparatively speaking, it has performed better because it has outperformed the index.

Types of alternative investments

Alternative investments include hedge funds, private equity, real assets, commodities, collectibles and derivatives.

1. Hedge funds

Hedge funds are investments that use pooled funds with the goal of generating high potential returns for investors.³ Unlike mutual funds, hedge funds consist of assets beyond stocks and bonds. Because of the inherent risk associated with hedge funds, most are only appropriate for accredited/qualified investors, those who could withstand the total loss of value of their investment.⁴

“We look for hedge funds with a unique skill set, competitive advantage and the potential to generate positive returns in difficult market environments,” Silberstein says. There are many different hedge fund strategies, he says, and some come with more risks than others. Additionally, hedge funds aren’t tax-efficient investments, so investors should work with a financial professional to ensure the anticipated after-tax return is consistent with their financial goals.

2. Private equity

Consider private equity as the alternative investing counterpart of publicly traded stocks. Unlike stocks, however, when a business seeks private investors, only accredited/qualified individuals may invest.⁶

“Successful private equity investments have historically shown the ability to outperform their public market proxies, whether it be bonds or equities,” Silberstein says. “Investors may benefit from investing in private equity funds whose investment teams are able to implement changes. Whether it be increasing revenues, cutting costs, or instituting changes among the executive decision-makers, these changes can equate to a higher valuation when the company is sold.” A successful private equity investor has the ability to spot funds that can turn around the fortunes of struggling companies.

There is the potential for some unique advantages for investors who successfully incorporate private equity into their portfolios, but there are also associated risks, including the full loss of the investment. In addition, private equity is considered an illiquid investment with no secondary market, so investors should be prepared to have their money tied up for at least 10 years.

In addition, companies seeking private investors are not required to disclose as much information as publicly traded companies, so it’s important to conduct research in advance and partner with a knowledgeable financial professional.

Typically, seeking a worthwhile investment in this area requires familiarity with a given sector. Silberstein recommends tapping into a network of investors and advisors to help source solid private equity opportunities.

3. Real assets

Real assets are an investment class that includes real estate and infrastructure. Real estate investment trusts (REITs) allow investors to purchase shares in portfolios with holdings in homes, apartments and forms of infrastructure such as airports and toll roads. Publicly traded REITs are available to all investors, while privately traded REITs are only available to accredited/qualified investors.⁷

Infrastructure can be a good way to diversify your portfolio. Silberstein says although infrastructure returns have underperformed public markets over the past 10 years, the returns are generally consistent and can have relatively low volatility. However, investors should be aware of the lack of liquidity often associated with investing in real assets.

4. Commodities and natural resources

Commodities are an investment class referring to raw materials used for consumption or industry such as produce, livestock, precious metals and fuels. When buying commodities or natural resources, you’re anticipating the price of a given product will increase at a later date.

Commodity prices have been volatile, and they are also highly affected by weather, such as droughts, floods and natural disasters. Silberstein suggests the everyday investor take caution and do their own research or contact a knowledgeable financial professional before jumping into the commodities market.

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5. Derivatives

Derivatives apply to many financial instruments, from stocks and bonds to commodities and currencies. They’re called derivatives because they’re derived from the prices that two parties agree upon with respect to these underlying assets.⁹ The performance of a given derivative depends upon the performance of the underlying assets.

Common forms of derivatives include:

Futures, in which two parties agree ahead of time on a future selling price for the asset, and
Interest rate swaps, in which the parties agree to exchange cash flows under different interest rates.

Although there are several derivative strategies, for the most part they’re used to hedge a portfolio or to generate a return regardless of whether the market is trending up or down. Keep in mind, however, that strategies that incorporate derivatives have risk of their own. For example, the implied leverage can result in larger than expected losses if the trade is not structured properly.

6. Collectibles

Collectibles — including fine art, classic cars, and wine — are another type of alternative investment. Many investors find collectibles to be an alluring investment because they can follow their passions and aesthetic choices while investing. While collectibles can offer high returns, they rely on the fickleness of taste and reputation.

In fact, Silberstein suggests most investors avoid collectibles. “There has been a great deal of fraud within the wine world, and it’s very difficult to determine what’s going to be the next hot collectible in the art world.”

What can alternative investment strategy look like for you?

As with any investment, it’s important to consider individual alternative investments within the larger context of your portfolio strategy.

Seek an alternative investment with a unique skill set and a competitive advantage within its market. According to Silberstein, investors should consider three potential benefits of alternatives within a diversified portfolio:

Reduce volatility
Increase returns
Provide diversification

“It’s tough to find one alternative that can do all three, but if you know how to source funds you can find those funds that may achieve two of three,” says Silberstein.

Investors might consider alternatives as another means of offsetting the risks they have in terms of stock and bond exposures. For example, if you have stock and bond investments, you might consider an alternative investment with a low correlation to the stock and bond market. This way, you’ll potentially gain access to a return stream less sensitive to market movement.

If you’re interested in entering the world of alternative investments, be sure to talk with a financial professional about which types can be an appropriate fit within your portfolio.

U.S. Wealth Management – U.S. Bank is a marketing logo for U.S. Bank.

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. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates and risks related to renting properties (such as rental defaults). The valuation procedures for these holdings are often subjective in nature. There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes and the impact of adverse political or financial factors. Derivatives can be illiquid, may disproportionately increase losses and may have a potentially large negative impact on performance. Employing leverage may result in increased volatility. These investments are designed for investors who understand and are willing to accept these risks. There are special risks associated with an investment in tangible assets, such as wine or artworks, including market price fluctuations, liquidity risks and impact of political, environmental and financial changes. In addition, unique expenses associated with these investments (i.e., purchase and sale, appraisal costs, storage, insurance) may adversely impact investment returns.

The Hedge Fund Research, Inc. (HFRI) Indexes are a series of benchmarks designed to reflect hedge fund industry performance by constructing composites of constituent funds, as reported by the hedge fund managers listed within the HFR Database. The HFRI range in breadth from the industry-level view of the HFRI Fund Weighted Composite Index, which encompasses over 2100 funds, to the increasingly specific-level of the sub-strategy classifications. Most HFRI Indices are equally-weighted composites while asset-weighted versions of some indices are also available. The S&P 500 Index consists of 500 widely traded stocks that are considered to represent the performance of the U.S. stock market in general.

Exploring alternative investments