When most people think about investing, their mind goes to the most common types of investments, like stocks or bonds, or their investment accounts, like their 401(k) or traditional or Roth IRA.
However, there is a wide array of investment options that can help you diversify your holdings so you are better prepared in the event of a major market meltdown. Essentially, alternative investments are supplements to traditional long-only positions in stocks, bonds and cash.
Who can invest in alternative assets?
Before diving into the types of alternative assets, it's important to know who is qualified to invest in these asset classes. They're considered alternatives because they aren't included in any of the asset classes that would be considered conventional, which are stocks, bonds and cash. These alternative assets are more complex and may be riskier than conventional ones because they usually aren't registered with regulators.
As a result, most alternative investments are open only to accredited investors. Accredited investors are those who have a net worth of over $1 million, excluding their primary residence, or earned income of more than $200,000 (or $300,000 for married couples) in each of the last two calendar years.
Financial professionals can also qualify as accredited investors without satisfying one of those two requirements, but until just recently, they must have had a Series 7, 65, or 82 license to do so. Recently, the House of Representatives passed a new bill that allows people with "professional knowledge through educational or professional experience" to qualify as accredited investors without holding any of those licenses.
The same day, the House also passed a new bill updating the official definition of an accredited investor. This bill gave the Securities and Exchange Commission discretion to decide which credentials are needed to be considered accredited. It also requires an SEC review every five years with amendments as needed.
What are the different types of alternative investments?
Broadly speaking, most alternative investments can be separated into two groups: public and private.
Public alternative investments definition
Public investments are those that report their holdings publicly. For example, hedge funds may be considered public investments because they must abide by certain reporting regulations with the SEC. In a hedge fund, your investment is pooled together with others' to be managed by a professional portfolio manager who uses many tools, including some more complex and high-risk methods, with the goal of earning above-average returns.
Hedge funds are considered public because they must file quarterly reports on their holdings, especially those in publicly traded stocks. Most hedge funds also send monthly or quarterly letters to their investors to share details on their views of the markets and sometimes additional details on their holdings, like what they think about the companies they invest in.
Hedge funds use an array of strategies to achieve risk-adjusted returns for their investors. Long/short equity funds often get most of the attention. Other strategies include global macro, commodities, risk arbitrage, event-driven, fixed-income arbitrage, relative value, and distressed securities. Today, multi-strategy and multi-manager firms are becoming particularly popular, as are hybrid funds that combine a traditional hedge fund structure with that of a private equity firm.
In some cases, exchange-traded funds (ETFs) might be considered public alternatives because they list their holdings publicly and are traded on exchanges like stocks. This is particularly true of ETFs that utilize structures similar to those of hedge funds, aiming for similar risk-adjusted returns.
Private alternative investments definition
Private alternatives include private equity (PE), which includes venture capital (VC), private credit, and infrastructure. PE and VC are similar to hedge funds in that they buy pieces of businesses, but they are privately held businesses rather than publicly traded ones.
Private equity and venture capital have become exceedingly popular in recent years because these funds have generated significantly better returns at a time when generating alpha, or excess returns on top of what a benchmark has earned, in the publicly traded markets has been extremely difficult.
Other types of alternative investments
Finally, some alternative investments aren't really public or private. These include commodities like gold, silver, grains, or oil, real estate, and cryptocurrencies. Non-accredited investors can invest in some of these other asset classes, like cryptocurrencies and real estate. Moving out to the far fringes of alternatives, some other options include art and collectibles, wine, farmland, and peer-to-peer lending.
In some cases, investors can invest in a fund that covers multiple individual assets within one of these other classes. For example, a growing number of crypto funds are providing easier access to multiple cryptocurrencies in one fund for investors who don't want to learn to navigate crypto exchanges. Real estate funds can also bundle multiple properties into one fund.
However, such funds often require investors to be accredited to invest in them.
The pros and cons of alternative investments
Like anything, there are pros and cons of investing in alternatives. On one hand, they provide diversification for your portfolio and the potential to generate returns or alpha in one area of the market when other areas are falling. On the other hand, alternatives are more complex than conventional assets and usually require investors to be accredited.
Investors are always advised to consult with an adviser and do their due diligence before investing in anything.
