Guide to Alternative Investments Part 2 – Types of Alternative Investment and Why They Make Sense in an Investor

cityscape-hedgethink Guide to Alternative Investments Part 2 - Types of Alternative Investment and Why They Make Sense in an Investor

In the previous part of this series, we gave a general outline of the reasons why investors might choose alternative investments – basically anything that doesn’t fall into the category of listed stocks and bonds or mutual funds – as a method of hedging against market risk and seeking outsize returns. While there is potential for substantial capital growth with ‘traditional’ investments of this type, the performance of these types of investment tends to be very much tied in with the performance of the markets, and if the markets go down, then so too do the value of your investments in them.

In the light of the recent financial crisis, in which billions were wiped off the value of pension funds and other long term retail investments, investors have increasingly seen the value of alternatives that have little or no correlation with the performance of capital markets. While for the most part these investments are risk-heavy, illiquid, and largely unregulated, when considered as part of a balanced, diversified portfolio they have the potential to offset some of the risks that come with traditional investments, as well as offering other benefits that we outlined in part 1.

Essentially ‘alternative investments’ is a wide umbrella term that covers all manner of investments – the one common denominator is that they all require the investor to do a fair amount of research into them before they can make a wise investment in them. The manner and type of this research differs from one asset class to another, and here we have given a broad outline of the attributes of the most popular alternative investment types, the homework that you would have to do before investing in them, a brief explanation of their advantages and disadvantages, and the profile of the type of investor that would be best suited to them.

Private Equity

To invest in private equity is to buy into a company that does not issue stock to the public. This will generally take the form of contributing capital to a company at an early or growth stage, and then receiving returns when the company reaches a certain stage, such as a merger or IPO. Private equity investment is most often used to fund high-technology startups in fields such as telecoms, biotech, and alternative energy. Private equity investments are, by their nature, very risky because they depend on the success or failure of a start-up company, but the rewards when it goes well can be massive. Some private equity investors take an active interest in the companies they invest in, while others take a decidedly more hands-off approach and invest in them through private equity funds. As with hedge funds, the bar for entry into private equity investing is high, but between 1990 and 2010, indexes of private equity funds outperformed the stock market.

Hedge Funds

Hedge funds are essentially a high-end version of mutual funds, where the fund managers have a lot more freedom – and a lot less regulation – than their mutual fund counterparts. This enables them to invest in a much bigger range of financial instruments, and this can bring strong returns even at times when the stock market and the economy as a whole isn’t doing so well. As with private equity funds, the bar for entry is quite steep, with minimum investment sizes often starting at $500,000 and above, and high management and performance fees to pay.

Managed Futures

Managed futures are similar in many ways to hedge funds, but with a focus on investing in futures and options in the commodities, currency and interest rate markets. These are much more heavily regulated than hedge funds, but they are much more accessible to the average investor, with some managers offering minimum investments of as low as $5,000. Because managed futures funds tend not to follow the trends of the other markets, they can be useful for diversifying a portfolio. Part of your research in identifying the appropriate managed futures program is to understand how the advisor manages risk. Futures trading involves a much higher amount of leverage which could equate into a high level of risk. That being said, if the manager hedges his strategy and takes offsetting positions, the overall risk of the program can be managed efficiently with lower volatility and draw downs than other long only investments.

Venture Capital

This is a type of private equity investment that is focused on businesses at a very early stage of their development, providing start-up capital for these companies and then hopefully seeing a return much further down the line – often as long as ten years – when the company is bought by another, or it issues stock to the public. Venture capital funds spread the risk between lots of different start ups, and usually only one big success is needed to outweigh dozens of failures and deliver a net profit. VC investments are highly illiquid, in that you may have to wait several years before you can cash them in, and as with hedge funds and private equity funds, the minimum investment is very high and you need to prove that you are an ‘accredited’ investor in order to qualify.

Real Estate

Real estate has always been a very popular alternative investment, as a growing population means that demand for property continues to grow. While the 2008 crash in US property prices made many investors nervous about investing in real estate, the low property prices created a huge opportunity for investors to buy up property while it was cheap and with opportunities to make sizeable profits in markets where real estate prices rebounded.

An individual investor essentially has three options for gaining exposure to rising property values. They can buy rental property as an individual, join a real estate investment group, or buy shares in a real estate investment trust (REIT). Buying rental property can provide a good, steady income if you find the right tenants, but it requires quite a lot of time and effort, and there are expenses such as upkeep and property taxes that can limit profits.

Real estate investment groups provide a lower-risk, hands-off method of investing in real estate, with a group of investors providing money to a company that purchases a property such as a condo development, and the company manages the property in exchange for a percentage of the rental income.

Another way to invest in real estate is via a real estate investment trust (REIT), which is a group that invests in various real estate properties, and pays out most of its income to shareholders in the form of regular dividends. These receive preferential tax treatment from the IRS, and share in REITs can be bought and sold on public exchanges, which makes them one of the most liquid types of alternative investment.

Fine Art

An investment in fine art has had little or no correlation with those of stocks and bonds historically. An investment in fine art can be a good way to diversify a portfolio of investments. Based on the Mei Moses Fine Art Index, the value of art has increased by an average of 10.5% per year over the second half of the 20th century. But while the art market and the stock market don’t move in tandem, there are shifts in the market that can make investing in it risky. For example, art prices went through the roof in the late 1980s and the mid-2000s due to an influx of Japanese investors, although the market did take a hit in the financial crisis of 2008.

Wine

Typically, a wine investor can expect to make steady returns of between 6 and 15 percent a year. However, it requires a lot of research in order to find out which vintages will make the best investments, and you may need to store large quantities in a climate controlled environment to make any substantial returns from it. This can be done through a third-party wine storage company, or you can purchase your own wine coolers for several thousand dollars.

Commodities

As one of the most volatile types of investment, commodities such as crops and livestock, fossil fuels such as oil and coal, and precious metals like copper and gold, are best suited to being long-term investments, as they can be a bit risky as short-term investments. One of the safest ways to make money from rising commodities prices is to buy into exchange traded funds (ETFs). These are basically mutual funds that purchase commodities or invest in commodity producing businesses, and the safest ETFs are the ones that spread the investment across several different commodities.

Although, as we stated earlier, alternative investments can be anything that doesn’t fall into the category of listed stocks or bonds and retail investment vehicles such as mutual funds, the vast majority of such investments fall into one of the categories listed above. In the next part of this series, we shall be taking a look at Private Placements, how they work, why an investor would want to invest in them, and the types of placements that are available.

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