Looking back over the past decade, it seems like everything has changed. The world is not the same as it used to be, and the financial markets are no exception. In the past, the 60/40 portfolio was the norm for investors. The strategy is to allocate 60% of an investor’s portfolio to equity and 40% to fixed income and cash. Haven’t heard of this concept? Simply put, financial advisors no longer recommend it. It’s also not accepted as the best investment strategy. Advisors and investors alike are now allocating alternative investments to their portfolios to diversify, minimize volatility, and enhance returns. The alternative asset class is not just for the financial elite either. It is gaining approval from retail investors and offers unique benefits for those interested in the space.
This guide will answer your questions about the alternative investments asset class, discuss the various types of investments, and highlight trends in the area.
What are alternative investments?
Any asset not considered part of the conventional asset classes is considered an alternative investment. Traditional assets include shares or bonds that trade on a public exchange, known as equity and fixed income, respectively. Cash is also considered part of the traditional asset category.
Specific examples of alternative investments include real estate, hedge funds, and equity or debt that does not trade on a public exchange. We will provide further details on these and other types of alternative investments below.
The main reason for investing in alternatives is to enhance diversification and boost returns within your portfolio. This asset class tends to have a lower correlation with traditional equity and fixed-income investments. With a low or uncorrelated return profile, investors who incorporate alternatives into their portfolios can achieve higher growth while maintaining a lower exposure to risk. Not only can this diversification lower risk, but it also minimizes the volatility of returns. This is the main advantage of investing in alternatives.
Alternatives can also act as a hedge against the positions in the rest of your portfolio. Uncorrelated returns mean that sometimes these assets will outperform when the stock market is experiencing a pullback.
Though alternative investments have several benefits, there are also drawbacks to investing in the space. Investments outside the traditional asset classes tend to have higher fees and reduced liquidity. For example, you can normally always know the value of your shares held in a publicly-traded company. You can also access the proceeds within three business days should you need to sell. This is not the case with alternatives. In some instances, you may not know the exact value of your venture capital or private equity investments. Even if you did, you might not have access to those funds for weeks, months, or even years. The longer time horizon and reduced transparency are part of the reason why investors get compensated with higher returns — a ‘lack of liquidity’ premium.
Some alternatives are only available to those considered “accredited.” An accredited investor has a high income, significant wealth, or thorough industry knowledge. These investors are qualified for additional opportunities, especially when it comes to riskier ventures or those that lock up money for a significant length of time.
Types of alternative investments
The definition of an alternative investment is quite broad, and the asset class covers a wide range of investments. Below, we review the types of alternative investments, examples of each, and how to invest in them.
Private equity represents an ownership stake in a company whose shares do not trade on a publicly listed exchange. The category is quite large and covers several sub-types. For example, private equity investors can own shares directly in a non-public company — i.e. not listed on a stock exchange.
Private equity can also be accessed through a private equity fund, which buys into a collection of non-public businesses. The fund will provide returns to holders as the underlying companies evolve. If a company performs well, goes through an IPO, or is acquired, fundholders benefit and receive a payout. On the other hand, if the underlying business fails or goes bankrupt, fundholders lose a portion of their money. For many investors, private equity is simplest when done through a private equity fund run by a professional fund manager with vast experience in the area.
Venture capital is part of the private equity class. Underlying companies must be in the early stages of their business life cycle to be considered venture capital investing. The range is typically from early-stage or start-up companies to growth-stage companies. As the companies do not have a long, established history, they are considered higher risk. In some cases, though, the risk can pay off with a substantial return. For example, if you were a venture capital investor in social media start-up Facebook back in the aughts, you would consider the risk worthwhile — as it would have paid off. What you do not often see in the media is stories of those companies that went bankrupt or the venture capital firm that lost their investment.
One way for accredited retail investors to get access to venture capital alternatives is through a venture capital fund. Sometimes called a VC fund for short, these invest in several early-stage companies knowing that not every investment will pay off.
Private debt, also known as private credit, is an increasingly popular investment that offers higher yields than traditional fixed-income securities. It is similar to publicly available debt, though it does not trade in the public exchange markets. Private lending is often issued to individuals and companies looking for financing, but cannot qualify for traditional loans from major financial institutions. Instead, the borrower seeks out alternative lenders and pays a premium price for the lending. An example of private debt would be an entrepreneur who turns to a privately held company to finance a business loan for their start-up company.
One of the best ways to invest in private debt is through an offering memorandum fund which will hold a pool of private credit loans. Generally, these funds are less liquid and reserved for accredited investors only.
Real assets involve investment in tangible assets. This category is quite broad and includes land ownership, commodities, precious metals, and collectible property. Investors concerned about rising prices can turn to tangible assets, which have historically acted as a hedge against inflation.
Those looking to invest in real assets can do so through alternative investment ETFs or direct ownership of the underlying asset.
Real estate, a sub-type of the real asset category, is an alternative investment many people are familiar with. It even extends beyond standard investment properties. To invest in real estate as an alternative investment without owning physical property, you can purchase shares in a Real Estate Investment Trust (REIT) or real estate trust. Additionally, you can invest in private mortgages through a Mortgage Investment Corporation (MIC). Regardless of how you invest in real estate as an alternative, you can receive many benefits, especially as the category can act as a hedge against inflation.
Hedge funds are a pool of investments that follow a specific strategy. There are multiple types of hedge funds, and each will follow a particular investment strategy. The hedge fund’s goal is to achieve positive returns regardless of the performance in the rest of the financial markets. They have a different structure than traditional mutual funds and have separate regulatory requirements.
An example of a hedge fund is a long/short fund that can purchase assets, or participate in short selling, to profit. Some long/short hedge funds will take a market-neutral approach where their assets are equivalent to their short positions.
You can invest in hedge funds through a hedge fund manager or investment firm. With high fees — and, at times, low liquidity — access to this alternative type is limited to institutional investors and accredited, high net worth investors only.
How much should I allocate to alternative investments?
The amount you should allocate to alternative investments will change depending on your liquidity requirements and investment objectives. Generally, high net worth individuals can allocate approximately 15-20% of their portfolio to alternatives. The chief investment officer at AGF Investments LLC, Bill DeRoche, agrees. According to DeRoche, this is the amount that institutional investors and endowment funds will allocate for their portfolios. He believes that the allocation may be right for individual investors as well.
Are alternative investments worth it?
Yes, it is likely worth it to invest in alternatives. There is a common misconception that they are all high risk. In reality, only some alternative investments are high risk. While several alternative investments have lower risk profiles, the actual risk of the investment is measured by its impact on the portfolio’s risk as a whole. In certain cases, adding a specific alternative investment can lower the portfolio’s overall risk because of its diversification benefits and uncorrelated return profile.
Before purchasing, it is imperative to understand each investment’s characteristics, risk profile, and how it impacts your portfolio as a whole. Ultimately, not every alternative investment will be right for every portfolio, and it is essential to be sure that you choose the suitable investment for you.
Alternative investment trends
The future of alternative investing has never looked better. Investors continue to search for ways to increase diversification in their portfolios, achieve higher returns, and hedge against the volatility of the financial markets. Alternative investments seem to be the answer, especially as they become more widely available and market valuations continue to set record highs.
Private equity has been growing at the fastest rate in the past few years, but a new trend is beginning to emerge as the ageing baby boomer population transitions to retirement. With traditional fixed income currently offering low-interest rates, the boomers and older generations are turning to private debt for higher yield. The Alternative Investment Management Association expects private debt assets to double in the next couple of years, reaching $1.4 trillion in 2023.
Retail investors are becoming more accepting of private debt, equity, and the alternative investment asset class as a whole. According to Morgan Stanley Research, high net worth investors had approximately $16 trillion invested in alternatives in 2020. Though the amount is staggering, they expect that allocation to increase to $24 trillion by 2024. The $8 trillion in growth is from retail investors pouring money into the asset classes.
Alternative investments have increased in popularity recently as investors search for ways to supplement the conventional asset classes. There are several types of alternatives, each with its own risk profile and investment characteristics. Before deciding how to invest in alternatives, you must first understand the investment and its correlation to the other assets within your portfolio. With ever-increasing options and ease of availability, it is clear that alternative investments are here to stay. It is worth considering how they can complement your portfolio and bring you closer to achieving your financial goals.
As always, we recommend speaking to your wealth manager if you have any questions about how alternative investments can fit into your portfolio, to help you reach your financial goals.