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What are Alternative Investments?
October 27, 2022
Traditional investment portfolios will usually consist of stocks, bonds, and cash. Sophisticated high net worth investors usually have more flexibility to invest in non-traditional or alternative investments that may offer opportunities to delve into other types of investments that could provide higher levels of diversification and lower correlation to traditional investments.
What is an Alternative Investment?
A financial asset that does not fit into one of the traditional investment categories is known as an alternative investment. Private equity or venture capital, hedge funds, managed futures, art and antiquities, commodities, and derivatives contracts are examples of alternative investments. Another popular category for alternative investments is real estate.
Consider an example of a strategy where you and your financial planner have established that your portfolio shall be made up of 70% equities and 30% fixed assets. If all equity asset prices fell by 10%, your portfolio’s allocation could probably shift to about 60% equities and 40 % fixed. You may raise your equity allocation back to the desired 70 % by using an opportunistic rebalancing method, which involves selling some of your fixed allocation and buying more equities.
Understanding Alternative Investment
Due to their complexity, lack of regulation, and level of risk, majority of alternative investment assets are owned by qualified, affluent individuals or institutional investors. In comparison to mutual funds and exchange-traded funds (ETFs), most alternative investments have relatively high investment requirements and cost structures. Additionally, there are fewer opportunities for these investments to promote to potential investors and provide verifiable performance statistics. While starting minimums and upfront investment fees for alternative assets may be expensive, transaction costs are often cheaper than those for traditional assets because of lower levels of turnover.
Particularly when compared to their conventional equivalents, most alternative assets are very illiquid. For instance, due to a lack of buyers, investors are likely to discover it much harder to sell an 80-year-old bottle of wine than 1,000 shares of Microsoft Corporation. Due to the rarity of the assets and the transactions surrounding them, investors may even find it challenging to appraise alternative investments.
As soon as you sell, buy a comparable investment to take part in the eventual rebound. In general, investors have the opportunity to keep exposure to the market while simultaneously profiting from downturns by recording losses to lower taxes. To avoid the IRS from disallowing the loss, be cautious not to buy the exact same investment or one that is “substantially identical” within 30 days of making the initial transaction.
Regulation on Alternative Investment
Alternative investments generally operate under a less defined legal framework than traditional investments. They are therefore covered by the Dodd-Frank Wall Street Reform and Consumer Protection Act, and the US Securities and Exchange Commission (SEC) is tasked with investigating their activities. They typically are not required to register with the SEC, though. As a result, unlike mutual funds and ETFs, they are not supervised or controlled by the SEC.
Therefore, it is crucial that investors perform thorough due diligence when looking about alternative investments. Several alternative products are only open to accredited investors. A person is considered an accredited investor if they have a net worth of at least $1 million (excluding their principal property) or an annual income of at least $200,000 (or $300,000 when including a spouse’s income). Accredited investors may also include financial professionals who possess a FINRA Series 7, 65, or 82 license.
Strategy for Alternative Investment
The connection between alternative investments and those in traditional asset classes is often minimal. They frequently move in opposition to the stock and bond markets because of their minimal correlation. They are a good instrument for portfolio diversification because of this attribute. Hard asset investments, like those in gold, oil, and real estate, also offer a strong defense against inflation, which reduces the purchase value of paper money.
Due to this, a lot of big institutional funds, including pension funds and private endowments, frequently dedicate a modest amount of their portfolios (typically just under 10%) to alternative investments like hedge funds.
Alternative investments are also available to non-accredited ordinary investors. Alternative mutual funds and exchange-traded funds, commonly known as liquid alts or alt funds, are currently offered. These alternative funds provide a lot of opportunities to invest in alternative asset classes, which were previously expensive and impossible for the typical person to access. Alt funds are subject to SEC registration and regulation since they are publicly traded, particularly under the Investment Company Act of 1940.
In a nutshell, the following are pros and cons of owning alternative investments:
Pros
Cons
Alternative to traditional assets- Diversification of portfolio
- Inflation hedge
- High payouts
- Low correlation to traditional investments
- Challenging to value
- Illiquid portfolio
- Lesser regulatory obligations
- High-risk
- Higher expenses
Disclaimer:
- The information provided is for educational purposes only and does not constitute personal financial, tax or investment advice and should not be relied on as such. It does not take into consideration any investor’s particular investment objectives, strategies, time horizon, and tax or legal status. Abacus Wealth International (AWI) does not provide tax or legal advice. Please consult a tax or legal professional for corresponding tax and legal advice.
- All material and content have been obtained from sources believed to be reliable. AWI does not guarantee the accuracy of the information provided and shall not be held liable for decisions based on the foregoing information.
- All examples of graphs, financial products and historical returns contained in the foregoing material are for illustration and educational purposes only and shall not be deemed as financial advice or recommendation. Past performance is not indicative of any future investment returns.