What Is an Alternative Investment?

An alternative investment is a financial asset that does not fall into one of the conventional investment categories. Conventional categories include stocks, bonds, and cash. Most alternative investment assets are held by institutional investors or accredited, high-net-worth individuals because of their complex nature, lack of regulation, and degree of risk.

Alternative investments include private equity or venture capital, hedge funds, managed futures, art and antiques, commodities, and derivatives contracts. Real estate is also often classified as an alternative investment.

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Alternative Investments

The Basics of an Alternative Investment

Many alternative investments have high minimum investments and fee structures, especially when compared to mutual funds and exchange-traded funds (ETFs). These investments also have less opportunity to publish verifiable performance data and advertise to potential investors. Although alternative assets may have high initial minimums and upfront investment fees, transaction costs are typically lower than those of conventional assets, due to lower levels of turnover.

Most alternative assets are fairly illiquid, especially compared to their conventional counterparts. For example, investors are likely to find it considerably more difficult to sell an 80-year old bottle of wine compared to 1,000 shares of Apple Inc., due to a limited number of buyers. Investors may have difficulty even valuing alternative investments, since the assets, and transactions involving them, are often rare. For example, a seller of a 1933 Saint-Gaudens Double Eagle $20 gold coin may have difficulty determining its value, as there are only 13 known to exist as of 2018.

Key Takeaways

  • An alternative investment is a financial asset that does not fall into one of the conventional equity/income/cash categories.
  • Private equity or venture capital, hedge funds, real property, commodities, and tangible assets are all examples of alternative investments.
  • Most alternative investments are unregulated by the SEC.
  • Alternative investments tend to be somewhat illiquid.
  • While traditionally for institutional investors and accredited investors, alternative investments have become feasible to retail investors via alt funds, ETFs and mutual funds that build portfolios of alternative assets.

Regulation of Alternative Investments

Even when they don't involve unique items like coins or art, alternative investments are prone to investment scams and fraud due to their unregulated nature.

Alternative investments are often subject to a less clear legal structure than conventional investments. They do fall under the purview of the Dodd-Frank Wall Street Reform and Consumer Protection Act, and their practices are subject to examination by the Securities and Exchange Commission (SEC). However, they usually don't have to register with the SEC. As such, they are not overseen or regulated by the SEC or the Financial Services Regulatory Commission as are mutual funds and ETFs.

So, it is essential that investors conduct extensive due diligence when considering alternative investments. Often, only those deemed as accredited investors have access to alternative investment offerings. Accredited investors are those with a net worth exceeding $1 million—not counting their residence—or with a personal income of at least $200,000.

Strategy for Alternative Investments

Alternative investments typically have a low correlation with those of standard asset classes. This low correlation means they often move counter—or the opposite—to the stock and bond markets. This feature makes them a suitable tool for portfolio diversification. Investments in hard assets, such as gold, oil, and real property, also provide an effective hedge against inflation, which hurts the purchasing power of paper money.

Because of this, many large institutional funds such as pension funds and private endowments often allocate a small portion of their portfolios—typically less than 10%—to alternative investments such as hedge funds.

The non-accredited retail investor also has access to alternative investments. Alternative mutual funds and exchange-traded funds—aka alt funds or liquid alts—are now available. These alt funds provide ample opportunity to invest in alternative asset categories, previously difficult and costly for the average individual to access. Because they are publicly traded, alt funds are SEC-registered and -regulated, specifically by the Investment Company Act of 1940.

Pros

  • Counterweight to conventional assets

  • Portfolio diversification

  • Inflation hedge

  • High rewards

Cons

  • Difficult to value

  • Illiquid

  • Unregulated

  • High-risk

Real World Example of Alternative Investments

Just being regulated does not mean that alt funds are safe investments. The SEC notes:

Many alternative mutual funds have limited performance histories. For example, many were launched after 2008, so it is not known how they would perform in a down market.

Also, although its diversified portfolio naturally mitigates the threat of loss, an alt fund is still subject to the inherent risks of its underlying assets. Indeed, the track record of ETFs that specialize in alternative assets has been mixed.

For example, as of March 2019, the SPDR Dow Jones Global Real Estate ETF had an annualized five-year return of 6.32%. In contrast, the SPDR S&P Oil & Gas Exploration & Production ETF posted a negative 14.7% for the same period.