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. Alternative investments can 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.
- An alternative investment is a financial asset that does not fit into 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 have fewer regulations from the U.S. Securities and Exchange Commission (SEC) and tend to be somewhat illiquid.
- While traditionally aimed at institutional or accredited investors, alternative investments have become feasible to retail investors via alternative funds.
- Common forms of alternative investments include real estate, commodities, cryptocurrency, and collectibles.
Understanding Alternative Investments
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. 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 11 known to exist and only one can be legally owned.
Types of Alternative Investments
Real estate as an investment includes investing in physical properties or property-based securities such as real estate investment trusts (REITs), real estate mutual funds, or crowdfunding platforms. In addition to capital appreciation of tangible assets, investors strive for operating income to potentially provide ongoing, stable cashflow.
Commodities are raw materials such as gold, silver, oil, or agricultural products. Investors can invest in these tangible goods that have real world uses and often perpetual demand due to the underlying characteristics of what they are. For example, gold's price is arguably more stable because it used in a variety of industries.
A blend of real estate and commodities, investors can turn to farmland as an alternative investment. In addition to reaping the benefits of physical, tangible land, farm owners may also receive ongoing cash proceeds should operations and sales of commodities yield positive results.
Art and Collectibles
Some investments may double as a hobby, with art, sports memorabilia, entertainment memorabilia, or other collectibles acting as an alternative investments. These items may have historical worth or develop worth over time as related parties (i.e. the artist, the associated movie star, or the associated athlete) become more historic.
The emerging form of digital currency, cryptocurrency is seen as an alternative investment as it outside the traditional scope of stocks and bonds. Though some may claim cryptocurrency does not offer a strong hedge against other risk-on investments, it may provide capital appreciation or passive income due to staking rewards.
Venture Capital/Private Equity
Blurring the lines of an alternative investment, venture capital or private equity are simply a refined branch of stock investments. Instead of trading shares of public companies in an open market, investors may seek alternative avenues to put capital into private companies or start-ups.
Investing in peer-to-peer lending translates to making loans to individuals or businesses through online platforms that connect borrowers with investors. Peer-to-peer lending takes a very similar form as investing with bonds, though it is done on more private markets and often entail transacting with riskier clients (thus with higher potential rewards).
The term "alternative investment" simply refers to an investment being alternative to stocks and bonds. Both an unboxed Star Wars figurine with appreciating value and a rundown local warehouse may fall into the definition of an alternative investment.
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 the lack of regulations.
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 U.S. 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 as are mutual funds and ETFs.
So, it is essential that investors conduct extensive due diligence when considering alternative investments. In some cases, only accredited investors may invest in alternative offerings. Accredited investors are those with a net worth exceeding $1 million—not counting their primary residence—or with an annual income of at least $200,000 (or $300,000 combined with a spousal income). Financial professionals who hold a FINRA Series 7, 65, or 82 license may also qualify as an accredited investor.
Some alternative investments are only available to accredited investors—e.g., those with a net worth above $1 million, or an annual income of at least $200,000.
Advantages and Disadvantages of Alternative Investments
Pros of Alternative Investments
Because of their unique nature and differences from traditional markets, alternative investments may have low correlations to traditional investments such as stocks and bonds. Therefore, investors most often turn to alternatives to potentially help diversify an investment portfolio and reduce overall portfolio risk.
Since alternatives are considered riskier investments, they often have the potential for higher returns compared to traditional investments. In addition, alternative investments come in different forms and structures, giving investors the flexibility to choose the investment that best suits their preferences, risk appetite, and investment goals. For instance, investors may favor certain cryptocurrencies based on passive income opportunities.
Some alternative investments boast protection against rising prices. For example, consider a real estate lease with built-in escalating rent price increases or commodities that are tied to current prevailing prices that can fluctuate up or down. As opposed to other forms of investment, investors can choose certain investments that may move in tandem with inflation.
Alternative investments may provide access to markets that are not available through traditional investments, such as emerging markets or niche industries. Not only may investors find this more interesting (i.e. a baseball enthusiast may find more passion buying an autographed baseball), that investor may find it more difficult to sell that good because of marketplace illiquid. This may be perceived as a benefit as this may enhance price stability amongst investors as there is less opportunity or panic sell or transact quickly based on emotion.
Cons of Alternative Investments
Because of their limited accessibility, alternative investments often have higher fees and expenses compared to traditional investments. For example, private equity and hedge funds typically charge high management and performance fees, which can significantly reduce investors' returns. Whereas many brokers offer free trades of many stocks and bonds, many alternative investment products come at a cost.
As mentioned earlier, alternative investments are often illiquid which may be a benefit. However, consider the situation where an investor needs to quickly sell a rare piece of movie memorabilia because they need the cash. Because there may not be an active or large market, they may not be able to easily or quickly sell the item without incurring significant transaction costs or loss of value.
Because alternative investments may not be commonly publicly traded, it may be more difficult to obtain market data on historical trends or pricing. Whereas public companies must comply with many reporting rules, some alternative investments may be subject to less regulatory oversight and have higher risk of fraud, misconduct, and other abuses. Also mentioned above, alternative investments tend to carry higher returns though this is a function of being riskier investments.
Alternative investments are also more often complex. Some may have complex structures and terms that can be difficult for investors to understand, increasing the risk of making uninformed or inappropriate investment decisions. Others may have no readily available market prices, making it difficult to determine their true value.
May offer diversification benefits
Often have higher return potential than traditional investments
May offer protection against inflation
May allow investors or more specifically select investment preferences
May be illiquid and more difficult to panic sell, creating unofficial price and value protection
Often are associated with higher fees and transaction costs
Often have higher risk than traditional investments
Often lacks regulation or transparency
May be more complex and difficult for novice investors to understand or make smart decisions towards
May be illiquid and more difficult to sell, creating barriers for those trying to liquidate
How to Invest in Alternative Investments
Getting started with investing in alternative investments is very different based on the alternative you're working with. Some may require substantial capital and research; others may simply require a few clicks of a mouse button. Very broadly speaking, here's how to get started with several types of alternatives.
- Private Equity: Private equity investments typically involve buying shares in a private company or a group of companies. Investors may participate in private equity investments through private equity firms, venture capital funds, or crowdfunding platforms.
- Real Estate: Investors can invest in real estate through various means such as buying rental properties, investing in Real Estate Investment Trusts (REITs), or investing in real estate crowdfunding platforms.
- Hedge Funds: Hedge funds are typically available only to accredited investors, and investors must have a high net worth and a substantial amount of investment capital to qualify. Investors can invest in hedge funds through hedge fund managers or brokers.
- Commodities: Commodity investments involve buying physical assets such as gold, silver, oil, or agricultural products. Investors can also participate in commodity investments through commodity trading platforms, exchange-traded funds (ETFs), or mutual funds.
- Art and Collectibles: Investors can invest in art and collectibles through art dealers, auction houses, or online marketplaces. Due to uniqueness of these goods, consider the reputation of the dealer when exploring avenues to trade.
- Cryptocurrencies: Investors can invest in cryptocurrencies though cryptocurrency exchanges, brokers, or online platforms. Investors must often deposit domestic currency into a digital wallet that will house the private keys and currencies of that investor.
As most alternative investments incur a transaction or processing fee, be mindful of maintenance or one-time fees when pursuing alternatives.
Tax Implications of Alternative Investments
Because they represent an entirely different asset class compared to stocks and bonds, many alternative investment industries have different tax rules. In addition, consider how different alternatives may have different income streams (i.e. capital gain on the sale of a rental property in addition to rent revenue).
Some alternative investments such as collectibles and art may not offer the same tax deductions as traditional investments like stocks and bonds. In addition, collectibles such as art or coins are explicitly defined by the IRS as a collectible, and net capital gains are subject to a maximum 28% tax rate.
Cryptocurrency and other digital asset tax rules continue to evolve. Digital assets such as virtual currency, cryptocurrency, stablecoins, and non-fungible tokens may incur taxable transactions when selling the asset for fiat, exchanging the asset for goods or services, or exchanging the asset for another digital asset. In addition, whereas fluctuations in the value of the U.S. Dollar would not incur a taxable event, fluctuations in value of digital assets often results in capital gains or losses.
Some alternative investments such as real estate and certain types of energy investments may offer tax-deferred or tax-free investing options. This may include 1031 exchanges and Opportunity Zone investments where investors can use proceeds from the sale of an alternative asset to invest in a similar or specific asset with those proceeds to avoid taxes.
As you embark on your alternative investment journey, consider speaking with a financial advisor in addition to a tax advisor to best understand how to protect your asset and ensure maximum efficiency in protecting returns.
What Are the Key Characteristics of Alternative Investments?
Alternative investments tend to have high fees and minimum investments, compared to retail-oriented mutual funds and ETFs. They also tend to have lower transaction costs, and it can be harder to get verifiable financial data for these assets. Alternative investments also tend to be less liquid than conventional securities, meaning that it may be difficult even to value some of the more unique vehicles because they are so thinly traded.
How Can Alternative Investments Be Useful to Investors?
Some investors seek out alternative investments because they have a low correlation with the stock and bond markets, meaning that they maintain their values in a market downturn. Also, hard assets such as gold, oil, and real property are effective hedges against inflation. For these reasons, many large institutions such as pension funds and family offices seek to diversify some of their holdings in alternative investment vehicles.
What Are the Regulatory Standards for Alternative Investments?
Regulations for alternative investments are less clear than they are for more traditional securities. Although alternative investment vehicles are regulated by the SEC, their securities do not have to be registered. As a result, most of these investment vehicles are only available to institutions or wealthy accredited investors.
The Bottom Line
Alternative investments are investment options outside of traditional investments such as stocks, bonds, and cash. Alternative investments may include a wide range of assets such as real estate, commodities, private equity, hedge funds, art, collectibles, or cryptocurrencies. These investments are generally less liquid than traditional investments, though they may boast diversification and higher returns compared to more popular forms of investing.