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June 23, 2020

4 Key Differences in Investment Alternatives to the Stock Market

Are you considering various investments to grow your capital? There are many options available, from stocks, ETFs, bonds, and cash to more exotic investments like cryptocurrency. Yet, every investment is different since each one has different risks, rewards, and regulations.

Many people start investing with simple choices such as stocks, ETFs, or mutual funds. More advanced investors might consider alternative investments like hedge funds, real estate, commodities, or cryptocurrency as they can produce higher returns. Below, you’ll learn about the key differences in investment alternatives to the stock market.

Liquidity

One of the biggest differences in alternatives to the stock market is liquidity. Liquidity refers to how easily an asset can be bought or sold without impacting value. Stocks are very liquid since you can buy and sell them throughout the day, which is referred to as intraday trading. Many stockbrokers like Fidelity also offer commission-free trading so you won’t lose money to transaction fees.

One common alternative investment that is very illiquid (not easily converted into cash) is physical real estate as it can take months to buy or sell this asset. For example, real estate has to go through escrow, which ensures that factors like title and home inspections are accurate. This process can take 6 weeks alone. You have to pay high commissions with real estate transactions as most real estate agents charge the seller 5% of the home’s sale price to sell the home.

Other alternative investments like hedge or private equity funds have lock-up periods that can tie up your money for up to five years. Be wary of hedge funds and other investments that have lock-up periods if you’re worried about liquidity.

Complexity

Investing isn’t easy, with some strategies being more complex than others. Complexity is a key difference with investment alternatives to the stock market. One common, simple strategy is buy and hold investing. You buy diversified investments like ETFs or mutual funds and hold them for decades, regardless of volatile markets. This is a typical strategy for younger investors saving for retirement.

Conversely, hedge funds, private equity, and other alternative investments are more complex. For instance, many hedge fund managers use intricate, but often high-risk strategies like arbitrage, using high amounts of leverage (i.e debt), shorting, and high-frequency trading. Top investment managers must constantly monitor their clients’ capital and can’t have a “set it and forget it” approach.

Only Available to Accredited Investors

Many alternative investments have stricter standards and regulations, due to their high-risk, high-reward nature. Hedge funds and the majority of private equity funds are only available to accredited investors. This type of investor must have a net worth of at least $1,000,000 excluding real estate or earn an annual income of $200,000 if single ($300,000 if married). 

These options are only open to accredited investors because the SEC wants to ensure that investors have enough capital to weather volatility and illiquidity. The SEC also limits these investments to accredited investors because they usually have more sophisticated investing knowledge compared to the average person.

Fees

One of the most important differences in alternatives to the stock market are fees. Most common stock investments like ETFs, individual stocks, and mutual funds can have minimal or low fees. Many brokers like Fidelity, Vanguard and Charles Schwab have free trading for US stocks and ETFs.

These brokers also offer funds with low or even no expense ratios. Low fee investing can make a huge difference and potentially save you hundreds of thousands of dollars long term. Private equity and hedge funds have very high fee structures that compensate fund managers. These fees are divided up between assets under management (AUM) and performance. 

The AUM fee is usually around 2%, which is fixed regardless of the fund’s performance. If the manager performs beyond certain thresholds, then you’d pay an additional 20%! This standard arrangement is known as the 2 and 20 model. 

Not all alternative investment options have high fees or lock-up periods. You can buy other alternative investments, like cryptocurrency, commission-free with online stockbroker Robinhood.

Support

Many household name stockbrokers have in-person, email, chat, or phone-based support. These make it easy for you to find answers to your investing questions. These companies also have intuitive and helpful tools like free stock screeners and research reports. If the company or fund is publicly traded, then you can use the publicly available 10K or 10Q reports for more in-depth research.

One of the biggest differences in alternatives to the stock market is support. It might be harder to receive quick, personalized support with a private fund manager. Many private investments like hedge funds, startups, and private equity also might not be registered with the SEC. They only need to register with the SEC if they surpass thresholds like $100 million AUM (hedge funds) or $150 AUM (private equity).

Registered or not, these funds aren’t as transparent as standard investment options like mutual funds or ETFs. They don’t have as much information available to the public. Before investing in unregistered alternative investments, conduct your due diligence on the manager, team, past performance, and investment strategies.

Bottom Line

It can be daunting to develop an investment strategy as there are so many options. Advances in technology have also created various alternative investment choices like cryptocurrencies that weren’t available just a decade ago.

It’s also common to start investing in relatively simple products like stock-based ETFs or mutual funds within an employer-sponsored plan like a 401(k). But, you might consider higher-risk, higher-reward investments once you have sufficient capital and knowledge. 

Some of the key differences in investment alternatives to the stock market include liquidity, complexity, regulations, fees, and support.

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