However, while bonds and equities have their merits, they can also be relatively limited in strategies and potential returns. So in addition to purchasing bonds and equities, it’s worth considering alternatives investments in order to build a well-balanced portfolio.
What Is an Alternative Investment?
Alternative investments are essentially any type of financial assets that aren’t bonds, stocks, or cash. These non-traditional assets are usually less liquid, which means they cannot be sold quite as quickly. Despite their relative illiquidity, individual investors value alternatives because they can help diversify portfolios effectively.
When investing in alternatives, it’s important to use strategies that focus on non-correlated assets for true portfolio diversification. If done properly, this will mean when movement occurs in one asset class, it won’t affect the whole portfolio.
The most common alternative investments include:
- Hedge funds
- Venture capital
- Private equity
- Private debt
- Real estate
Types of Alternative Investments
If you elect to invest in alternatives, there are many different types of non-traditional investments you can choose from. Each type requires you to implement different alternative investment strategies and risk-free management approaches to obtain high returns.
1. Hedge Funds
Hedge funds are pooled investment funds that trade relatively liquid assets and employ complex strategies such as using leverage, hedging, options, and futures trading. Hedge fund managers are skilled in employing volatility arbitrage and carefully balancing option Greeks. At e360 Power, we engage in commodity investments including power, natural gas, and emissions.
Commodity investing usually involves buying and selling natural resources such as gold, silver, copper, wheat, coffee beans, oil, natural gas, and others. The two commodities utilized by e360 Power are electricity and natural gas, both of which are essential for homeowners and businesses.
Commodities are often used as a hedge against inflationary conditions since they aren’t very correlated with public equity markets. Instead, the value of commodities moves with the fundamentals of supply and demand.
3. Venture Capital
Venture capital is a type of private equity that focuses on investing in the growth phase of a startup or emerging company. Venture capital firms invest in early-stage companies in exchange for equity in the company. Venture capitalists take on the risk of financing nascent start-ups for the potential reward of extremely high returns. The firms raise capital from institutional investors or high net-worth individuals. Venture capital firms were involved in the early stages of Facebook, Twitter, and Google.
4. Private Equity
Private equity refers to investment funds that buy and manage companies before selling them. They may acquire private companies or public ones, but once they buy a public company, it will no longer be listed on a stock exchange. In contrast to venture capital, private equity firms invest in established companies rather than start-ups. For the acquired company, private equity firms can deliver mentorship, industry, expertise, or help with talent sourcing. Their capital can be used to fund new technologies or expand working capital. All of this is done to boost the value of the company, at which point the private equity firm can exit the investment with a nice profit.
5. Private Debt
Private debt refers to loans that are made by non-bank investors. Companies will access private debt to expand their working capital, finance growth, or fund real estate development. Private debt can also be acquired by other sources after it is issued to a certain company. The return from private debt investments comes in the form of initial loan repayment plus interest payments. The private debt market has grown tenfold in the past decade. However, the lack of available data available and the distribution of debt across lending platforms make it hard to ascertain how much risk is in the market.
6. Real Estate
Real estate is property consisting of land and the buildings and natural resources on it. Investing in real estate involves anything from buying an apartment complex to flipping a house for high returns. Even though real estate is considered to be an alternative investment, it has similar characteristics to bonds.
The purpose of a real estate investment is to increase the asset's value via capital appreciation, so returns are available in the form of equity. You can also obtain returns by collecting rent payments, similar to collecting the dividends of a stock. Before beginning a journey in real estate, it’s especially important to be familiar with the many types of valuation methods used.
Investing in Alternatives vs. Traditional Investments
Before deciding what weight to give various investment strategies in your portfolio, it’s important to compare the advantages and disadvantage of alternatives compared to traditional investments. Non-traditional investments can have extremely high returns, but also come with inherent risks you should be aware of.
Benefits of Alternative Investments
Advantages of alternative investments include:
- Potential for High Returns: Investing in alternatives can be highly advantageous. Just think of the venture capital firms that invested in Google or Facebook, or the Austin real estate market that jumped 170% in ten years. If you are knowledgeable about the investments you're making and are willing to take on the higher risk, these investments have the potential for some of the highest returns.
- Hedge Against Inflation: Alternative investments, especially commodities, tend to weather the storm of inflationary conditions much better than stocks and bonds. Additionally, the demand for commodities can be relatively inelastic, meaning people will still buy many commodities despite adverse economic conditions.
- Portfolio Diversification: Because alternative investments don't correlate well with the overall stock market, it's possible to diversify your investment portfolio with alternative investments.
Disadvantages of Alternative Investments
The risks to be aware of when investing in alternatives include:
- They can be difficult to access since there are limited offerings available to the public.
- The varying fee structures can sometimes be quite high.
- There are relatively high minimum investments. Many of these assets are only available to institutional investors or high-net-worth individuals who have become accredited, meaning they have a $1 million net worth or at least $200,000 in income.
- There is less regulation because alternative investments don't necessarily need to be registered with the SEC, which means that they are riskier than mutual funds.
How to Invest in Alternative Assets
Even though the majority of alternative investments are only available to high-net-worth individuals or institutional investors, there are several non-traditional investments that non-accredited investors can take advantage of. For example, some ETFs and mutual funds which track alternatives are available to individual investors. Through these avenues, individual investors pool their money together, which enables investment in high-cost alternatives. Unlike a direct investment in alternatives, ETF and mutual fund alternatives are traded publicly, which means they are registered with the SEC.
Busting Alternative Investment Myths
Since alternative investments (as the name implies) aren't as common as traditional ones, numerous myths have been dispersed about them. It’s important to dispel these myths in order to ascertain the most accurate view of alternative investments.
Myth 1: Alternatives Have More Volatility than Bonds and Stocks
Alternatives aren't necessarily any more or less volatile than traditional stocks. Alternative investment markets are certainly less understood and scrutinized than the stock market, but this doesn’t necessarily equate to an increase in volatility.
Myth 2: Alternatives are Considered a Single Asset Class
Alternative investments involve many different types of asset classes as we’ve covered above. Any type of financial instrument that isn't a stock, bond, or cash can be considered an “alternative.”
Myth 3: Investing in a Single Alternative Fund Diversifies My Portfolio
It takes numerous investments in a variety of alternative funds to properly diversify any portfolio.
Myth 4: Investors are Unable to Access their Money When Investing in Alternatives
Even though most alternative investments are illiquid, this doesn't mean that you can't gain access to the funds that you've earned. Some mutual funds may offer access to cash daily. Other investments can offer access in a timeframe ranging from 30 days to 10 years.
Myth 5: Alternatives were Unable to Protect Investors While Market Downturns were Ongoing
Myth 6: Alternative Investments are Too Costly
Because alternative investments were initially only purchased by individuals who were highly capitalized, many people assume that alternatives are only for the extremely wealthy. However, there is a wide range of fees in the investment structure, resulting in a lower end that is much more affordable.
Diversify Your Portfolio with Alternative Investments
Alternative investments are the perfect way to diversify your portfolio. While many of these investments come with a relatively high amount of risk, they are varied enough to ensure that your portfolio takes on the exact amount of risk that you want it to. Whether you would like to invest in real estate or hedge funds, you should be able to find alternative investments that match your investment strategies and provide you with the returns you seek. Contact our team at e360 Power to find out how we can help you invest in alternatives.