Investors seeking to potentially generate more returns, reduce their exposure to volatility and diversify their investments often consider alternative investments. With the right approach, these investments are compelling and can provide additional avenues for investment growth. Kevin Neal, a former independent financial advisor (IFA), knows that to appreciate alternative investments and their value fully requires an understanding of their difference from traditional investments
Traditional investments (or asset classes) are those that would typically come to mind when thinking about investments. For the most part, these are cash, bonds and stocks. Cash and cash equivalents (treasury bills, money markets) are the most liquid assets, while bonds are debt investments where investors loan money to borrowers (mostly large corporations and government entities) at a determined interest rate. Lastly, stock investments are securities that provide investors with an ownership stake in a business. These can be bought and sold on the stock market.
On the other hand, alternative assets fall outside conventional investments and can include lesser-known assets available to investors. Some of these are:
- Commodities: Commodities are goods produced for use by consumers and can be indistinguishable when made by different producers. Major examples include energy, agriculture, meat and precious metals.
- Collectables: These are items whose rarity tends to drive up their demand. Examples include vintage wine, coins, antiques, fine art and classic cars.
- Derivatives: These are financial contracts whose value is derived from the performance of another asset. Examples include futures contracts.
- Real Estate: Real estate encompasses residential and commercial properties, as well as real estate investment trusts (REITs).
- Venture Capital: Venture capital describes the investments made into start-ups and small businesses that show the potential for long-term growth and scalability. Typically, venture capital investors tend to be wealthy and have a high-risk tolerance.
- Hedge Funds: Hedge funds pool together funds from different investors and invest them in different asset types and strategies. They’re separate from venture capital funds as they typically invest in public equities (stocks) and are generally more liquid.
How They Work
The basis of coming up with an investment portfolio is to maximise returns while reducing exposure to risk. Achieving this can be done through diversification, which is a key element in investments. Alternative asset classes play a role in this regard, as typically their correlation to traditional assets is low. In fact, some alternative assets can gain more during periods of market volatility, currency drops or general economic slowdowns, so investors turn to them to boost their chances of generating higher returns.
Many alternative investments tend to be illiquid, meaning they’re not easily converted into cash. For example, an investor might find it hard to sell a decades-old bottle of vintage wine compared to 100 shares of a publicly-traded company. The difficulty is also present when it comes to valuing alternative investments. For instances, determining the value of a rare, centuries-old gold coin may not be easy, especially if only a handful of the coins were manufactured and very few assets compare to it.
The majority of alternative assets have a high fee and minimum investment structure when compared to traditional investments. These high fees mean that typical investors are probably of an institutional-nature, or high-net-worth individuals who can afford it. While these fees can be out of reach to many retail investors, the transaction costs are usually low due to reduced turnover by investors.
Due to their unregulated nature, alternative investments are sometimes prone to fraud and scams. In countries such as the United States, firms that provide alternative assets investment are reviewed by the Securities and Exchange Commission (SEC) but don’t have to register or be overseen by the authority. For investors, due diligence is necessary, if not mandatory, when signing up for alternative investments.