Have you been investing in traditional options like stocks, bonds, and mutual funds? These can be great tools to build wealth, but there are more investment choices for you to build a well balanced and high-growth portfolio. For example, alternative asset classes like private equity and real estate can provide greater opportunities than an S&P 500 index fund. Per the National Bureau of Economic Research, each dollar invested in the average private equity fund returned at least 20 percent more than a dollar invested in the S&P 500.
This shows the potential power of alternative investment strategies, which you’ll learn more about below!
Table of Contents:
- What are alternative investments
- The risks of alternative investments
- Advantages of alternative investing
- How to get started with alternative investments
- Common types of alternative investments
What are Alternative Investments?
Alternative investments or non-traditional investments are simply those that can’t be classified as stocks, bonds, ETFs, index funds, and mutual funds. Many simple bank investment options like CDs and money market funds are considered to be traditional investments. Also, alternative investments can be intangible like private equity fund shares, or tangible like physical art. Having rental properties can also be considered to be an alternative investment class.
Historically, either accredited investors or institutions have invested in these non-traditional investments. An accredited investor either has an annual income of $200,000 or a net worth of $1m, excluding real estate holdings. Many of these options like hedge funds or private equity cater to these two investor groups as they have high minimums, high risk/high reward, and are more complex.
However, alternative investing is evolving as more and more opportunities are opening up for everyday investors to participate.
Risks of Non-Traditional Investments
Before diving into the benefits and ways to invest in alternative asset classes, it’s important to mention some of the risks.
Liquidity refers to how easily you can buy or sell an asset with minimal transaction costs. Thanks to online brokers, you can buy or sell US stocks commission-free on the same day. Yet, alternative investments like real estate can take months to buy or sell. Besides that, many alternative investing strategies have high transaction and exit fees. Exit or termination fees can vary, but they can reduce your initial investment by up to 10% should you sell prematurely.
Like commission-free trading, 0% expense ratio funds are becoming more popular. Investing in mutual funds with low or no expense ratios can add hundreds of thousands of dollars to your net worth over time. But, alternative investing strategies like using hedge funds may have expense ratios over 2%!
Many alternative investments are more complex than simple stocks or bonds. They have unique rules like investment minimums, exit fees, and use advanced investing strategies. Many hedge funds and private equity funds implement complex trading actions like using high leverage (debt), event-driven investing, fixed income, and convertible arbitrage.
Investors who are new to alternative investing will need to make sure they are comfortable with an investment that behaves differently from what they are used to.
Advantages of Alternative Investment Strategies
Alternative investments, especially precious metals like gold, can be excellent tools to combat inflation. Unlike paper assets such as cash or open-ended mutual funds, there is a finite supply of gold. Gold also has uses beyond storing wealth as it’s used in dentistry, computer chips, and medicine. Real estate can be a hedge against inflation, especially since landlords can raise rents each period.
Potential for High Returns
If you’re looking for higher returns, then alternative investing can provide those. For example, some ways to access higher returns are to invest in private companies. Some private companies are high growth, volatile startups, which described Google in its early stages.
Since then, it has gone public with its share prices skyrocketing. Hedge funds can provide higher returns since they have highly educated fund managers conducting high risk, high reward strategies.
Inversely Correlated for More Diversification
Correlation refers to two investments that perform similarly during certain market conditions. One of the main advantages of alternative investing is that it can be inversely correlated to standard options. Inflation can wreak havoc on bonds, so it might be wise to invest in alternative asset classes that perform well during inflation like gold.
Taxes can vary greatly based on different investments, account types, and your unique background. Yet, alternative investments like real estate have several tax advantages. For example, you can deduct property taxes, mortgage interest, rental real estate expenses, and depreciation. On the other hand, you’ll be subject to high ordinary tax rates when you buy or sell stocks within a year in a brokerage account or withdraw from an IRA/401(k).
How to Start with Alternative Investing
Options for non-accredited investors to invest in non-traditional asset classes are growing. Example categories that are now available to all investors include cryptocurrency, peer to peer (P2P) lending, private companies, real estate, collectibles, and more.
Several online cryptocurrency exchanges will let you securely buy, sell, or trade cryptocurrency like Bitcoin, Ethereum, Ripple, and more starting with very low minimum transactions. It’s easy to create an account online and link your bank for quick deposits.
Peer to Peer (P2P) Lending
With P2P lending, you act as a bank and loan people money who apply for financing. You can create a portfolio of loans based on size and risk. Riskier loans are given to people with lower credit scores and come with higher rates.
Equity crowdfunding is similar to P2P lending as private companies can gain capital by selling equity or shares of their stock. There are several popular equity crowdfunding platforms available for all types of investors to invest in pre-vetted startups. Keep in mind that it’s harder to buy and sell investments compared to US stocks at a standard brokerage due to required holding periods.
Private Real Estate
In the past, the only way you could invest in real estate was to buy physical property. But buying your own can be expensive since it requires high down payments, maintenance, and other hidden costs. Most investors also do not have enough capital to invest directly into higher value real estate categories such as residential commercial real estate (such as multifamily properties) or business commercial real estate (retail or office space).
Today, everyday investors have the ability to invest in a diversified portfolio of fully-vetted commercial real estate properties without the high cost of entry. DiversyFund is one of the handful of platforms that provides online access to this type of investment.
A Closer Look into Common Types of Alternative Investments
There are many types of alternative investments, but it’s wise to know about the most common ones like private equity, hedge funds, tangible assets, and real estate. You’ll learn about the high-level mechanics of each of these below!
Private equity is a broad field that invests in private companies that haven’t gone public yet. It can be a great way for established entrepreneurs to raise capital without the headaches of listing on the NYSE also known as “going public”. Institutions and accredited investors can access high growth companies before they’ve reached their peaks via private equity. Private companies can use investors’ capital to make acquisitions, grow their teams, and create new innovations.
Investors or funds can either invest in these companies directly or participate in buyouts. Buyouts can fund acquisitions, which refer to one company purchasing another. This can be done to improve existing products and services so that they can become more valuable.
Another common type of buyout uses leverage (i.e debt) to purchase companies or delist them. Delisted companies are removed from public exchanges, which could allow them enough time to make positive changes to their leadership or operations.
Private equity is often confused with venture capital as they’re both very similar. Yet, venture capital refers to funding new businesses, not established ones. Both of these alternative investment classes have fund managers who are compensated with a management fee and performance fee.
The management fee hovers around 1.2-2%, which covers many operational expenses. The performance fee, or carried interest, incentivizes the managers to have high performance, by granting them 15-30% of the fund’s net profit.
Hedge funds are like mutual funds since they pool together investors’ capital to invest in various types of companies. The biggest difference between hedge funds and private equity is that hedge funds invest in a basket of companies like a mutual fund, while private equity invests directly in companies.
Like private equity and venture capital, hedge funds are usually reserved for institutions and the ultra-wealthy. Some hedge funds require high minimums which can be greater than $100,00 to start investing. Besides this, hedge funds also charge an expense ratio and a carried interest to compensate its personnel.
Hedge funds also place a higher focus on short term profits, compared to long term gains. These funds invest in different assets like stocks, currencies, commodities and anything else the fund manager thinks will be profitable. Hedge fund managers also use debt to magnify gains and invest in derivatives like futures or options.
Derivatives refer to contracts that speculate on price movements of underlying investments, not the investment themselves. Options are derivatives since they are contracts between two parties that bet on the prices of stocks or even indexes.
Tangible assets are a unique category since these are physical assets you can touch. This alternative investment class includes precious metals (gold, silver, etc.), timber, artwork, wine, and antiques. These alternative investments can be very useful during high inflation since they have a capped supply.
Many of these assets like old coins or rare works of art can be very illiquid. It can be hard, if not impossible to find replicas of certain paintings or wines. These can be valuable due to their rarity, age, or other factors. But, be sure that you can find a reputable buyer or seller.
Unlike common investments like stocks or mutual funds, these assets can be tough to appraise. There are more factors behind the valuation of these rare investments like requiring in-depth knowledge of obscure topics. After all, most people aren’t well versed in 17th-century French art!
Also, rare alternative investments like vintage paintings or wine have unpredictable demand patterns, which convolutes valuations. They aren’t as cut and dry as publicly traded stocks.
Real estate is one, if not our favorite alternative investment class. The wealthy have used real estate to diversify their funds, pay less in taxes, and give to their future generations.
Although most real estate investment opportunities have historically only been available to the high net worth and institutions, there are several ways for everyday investors to participate in real estate investing.
The most accessible ways to invest in real estate for non-accredited investors include:
Investors with enough starting capital may purchase rental properties and generate income from the rents. This type of investment requires hands-on daily management, downpayment and most likely debt financing. It’s possible to delegate these hands on tasks by hiring a property management company (although that adds to the investor’s cost).
Real estate investment trusts (REITs)
Publicly Traded: As the name implies, these REITs are available on public exchanges. Being on public exchanges makes them more liquid, which means that investors can buy or sell them easily. Investors can obtain detailed information about these REITs via documents like the 10K and 10Q.
Publicly Non Traded: Like publicly traded REITs, these are registered with the SEC. Both accredited and non accredited investors can invest in these types of REITs. However, public non-traded REITs don’t trade on exchanges and this allows the managers to not have to worry about daily market fluctuations. Non traded REITs are less liquid and investors have to check with the company’s redemption programs before trading.
REITs can also specialize in certain sectors like office, industrial and shopping malls. They can also niche down by choosing to be an equity, mortgage or hybrid REIT.
Equity REITs earn revenue via managing properties and collecting rents, while mortgage REITs earn funds by investing in mortgage backed securities. Mortgage REITs generate revenue by earning interest on funds lent to property owners. Hybrid REITs are a cross between the two as they earn revenue from both rents and loan interest.
Stocks, bonds, and index funds can be useful, but many investors like to have more diversification. Non-traditional investments can be a powerful way to diversify funds and gain higher returns. Yet, many types of alternative investments like hedge funds have strict requirements like requiring investors to be accredited.
So, be sure to conduct proper due diligence before investing in these classes and understand what you’re investing in.
After all, investing legend Warren Buffet mentions that true risk comes from not knowing what you’re doing and to “Never invest in a business you cannot understand.”