Financial advisors are as diverse in their investment styles as mutual funds. Funds can range from conservative fixed income portfolios that protect capital to leveraged ETFs that amplify the ups and downs of broad market indexes. Likewise, advisors can keep their recommendations limited to varying allocations of the traditional asset classes such as stocks, bonds, and cash — or they can employ more complex portfolio strategies involving alternative assets.
The most effective financial advisors are those who can play either role, depending on the client’s investment timeline, risk tolerance, and financial situation. That’s because no one portfolio type or asset allocation is appropriate for every investor. Financial advisors who understand the full range of investments, including alternative investments, are better prepared to develop personalized wealth plans for all of their clients, from the conservative to the risk tolerant.
Here’s a closer look at what alternative investments are, how they work, and which alternative asset types are most popular among investors who are new to this space.
What are alternative investments?
Alternative investments are assets purchased for price appreciation or income that do not fall into the standard categories of stocks, bonds, or cash. Real estate is the best-known alternative asset, but there is a huge range of other, lesser-known asset types that may have a role to play in your clients’ portfolios. The options range from tangible assets like classic cars or fine art to financial assets such as cryptocurrencies and venture capital.
Each type of alternative investment has unique characteristics, in terms of how the asset’s value behaves relative to economic and financial market trends. For that reason, alternative investments are often used to refine the behavior of an investor’s overall portfolio and insulate wealth from broader issues like systemic financial crisis.
What are the benefits and risks of alternative investments?
Alternative investments can be lucrative, but they’re not for the faint of heart or for the hands-off investor. They’re better suited for the individual who understands and accepts the benefits and trade-offs associated with these non-traditional asset types.
Benefits of alternative investments
Specific alternative assets have their own unique advantages. Gold, for example, is often used as a hedge against inflation. But there are also benefits that apply to alternative assets as a whole.
- Asset diversification: Alternative assets have a low correlation to the financial markets. They may hold their value or even increase in value during a bear market, for example. That’s useful from a diversification standpoint; wealth invested in alternatives is somewhat sheltered from being degraded by macro trends.
- Ability to invest using tax-efficient accounts: Many alternative assets can be held within a self-directed IRA, which offers tax-free contributions and tax-deferred earnings growth. Specifically, retirement savers can hold investment property, livestock, bitcoin, tax lien certificates, mineral rights, and other niche investment types in a self-directed IRA.
- Option to invest in personal interests: Alternative investments can be far more interesting than shares of Walmart or Amazon. Your clients who have a personal interest in classic cars, wine, racehorses, or even certain types of innovation may find it incredibly rewarding to invest directly in those interests.
Risks of alternative investments
As with the benefits, there are risks that apply to both individual asset types and the category of alternatives as a whole. Here are three of the broader issues your clients might face when investing in alternatives:
- Can be higher risk: Alternative investments are often less predictable and more volatile than traditional stocks and bonds. Still, many investors are willing to accept the higher risk for the potential of a steeper growth trajectory.
- Lack of pricing transparency: Many alternative investments are not exchange-traded, which means those assets are not being continually repriced according to supply and demand. Investors therefore will have less ongoing visibility into the asset’s market value.
- Less liquidity: Alternative assets are generally less liquid than stocks or bonds. Investors may need to hold alternative assets for long periods of time before seeing any return.
Types of alternative investments
There’s no single, exhaustive list of alternative investment examples. That’s mainly because the category is constantly expanding by way of cryptocurrencies and new crowdfunding platforms like MasterWorks, Rally Rd, Prosper, and MyRacehorse. However, the investor looking to break into alternative investments for the first time is probably best suited for more mature alternatives anyway. Seven of the more common alternative investment ideas are introduced below.
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Private Equity
A private equity investment provides capital for businesses that are not publicly traded. An investor could participate in private equity through a fund or directly, as an angel investor. Private equity funds are pooled investment vehicles managed by private equity firms — similar to a mutual fund, except that they are not SEC regulated and usually only available to accredited investors.
Angel investors, on the other hand, do not have to be accredited. They typically invest only in business models they understand and can support in a hands-on way. The angel often works directly in the business, providing relevant expertise, guidance with respect to strategy and implementation, as well as the all-important network of contacts.
1. Venture Capital
Venture Capital (VC) is a subset of private equity that finances early-stage start-up companies with high growth potential. Up until recently, only accredited investors could access VC investments through funds like Sequoia Capital, Accel Partners, and Greylock Partners. Today, platforms like MicroVentures and SeedInvest provide access to the VC market for accredited and non-accredited investors.
2. Hedge Funds
Hedge funds are actively managed pooled investment vehicles that use complex trading strategies and alternative assets to generate high returns for shareholders. A hedge fund might invest in distressed assets, options and other derivatives, currencies, as well as long and short equity positions. Many hedge funds also use leverage to boost their returns. They can be more liquid than other alternative investments, which is an advantage — but hedge funds operate with far less SEC oversight than mutual funds or ETFs. Hedge funds are typically available only to accredited investors.
3. Private debt
Private debt can be any loan made to a business or individual. The lender supplies an influx of cash, in return for repayments plus interest. An investor could loan money directly to a small business, for example, and take a security interest in the business assets as collateral. More commonly, accredited investors will buy into a private debt fund, which manages a diversified portfolio of loans. Businesses and individuals typically seek out private lenders when they don’t qualify for affordable bank debt. Private investors/lenders can fill this funding need while earning higher returns than they’d get from public debt securities.
4. Real Estate
Real estate may be the most popular alternative investment, probably because it’s widely accessible and less complex than, say, hedge fund investing. Traditional real estate investors buy residential or commercial properties, and then generate their profits through ongoing lease payments or by renovating the properties and reselling them.
Investors who prefer a hands-off approach can buy into a crowdfunding real estate platform like Fundrise or purchase shares of real estate funds and real estate investment trusts (REITs).
5. Commodities
Commodities are raw materials like grains, precious metals, oil, and natural gas. Because commodity prices rise when inflation is increasing, these basic goods are commonly used as a hedge against inflation. Investors can participate in the commodities market by purchasing the material directly, using futures contracts, or holding shares of an ETF that owns the commodity. An example of a commodities ETF that is backed by the actual material is the Perth Mint Physical Gold ETF (AAAU).
6. Life Settlements
Life settlements are purchased life insurance policies. Investors obtain the life insurance at a discount from its face value and then later collect the policy’s full death benefit when the insured passes away. It’s a fairly low risk investment, because the value of the policy is guaranteed — there’s no fluctuation based on market or economic conditions. The only real unknown for the investor is the timeline, though the investor can examine medical records to get an estimate of the policyholder’s estimated life expectancy.
Investors can purchase life insurance directly by working with life settlement providers. Going this route, the investor can review the policy details of each policy and handpick the most suitable investment opportunities for their portfolio.
Life settlement funds are also an option for investors who don’t want to do their own research or prefer the diversified approach. A fund would hold a portfolio of policies, which can be less volatile than a single life settlement. The investor, however, has to trust the fund’s screening process matches his or her investment preferences. Also, life settlement funds do charge management fees which lower shareholder returns.
