What are alternative investments?

Alternative investments may help diversify your portfolio and potentially hedge against market uncertainty.

Investors are increasingly interested in alternative investments when looking to diversify their portfolios more broadly. Along with the growing popularity of these types of assets, there’s an expanded universe of choices within the alternatives category.

Alternatives tend to be more complex investments and can, in many cases, move counter to stock or bond markets, which may make them an effective portfolio diversification tool. There are a wide variety of alternative investment strategies, though the most common vehicles are private market investments and hedge funds.

The evolution of the alternative investment category has improved individual investor access. Alternatives may be a worthy consideration to fill out your portfolio. As you assess your options, it can be helpful to understand more about what they are and how they work.

What are alternative investments?

At its most basic, an alternative investment is one that does not fall into a conventional investment category, such as stocks, bonds or cash.

Alternative investments originally grew due to the interest of large institutional investors such as managers of pension funds, endowment funds and foundations. “Institutions looked to benefit from both return enhancement and the non-correlation of returns to those of traditional investments,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management.

A key distinguishing feature of alternative investments is they’re often expected to generate an absolute return, independent of any benchmark.¹ In other words, the performance of an alternative is not measured against another category of investments but is measured on its own performance in a given time period.

Another notable factor is that alternatives are actively-managed funds overseen by professionals with a unique skill set. “Alternatives often involve complex trading strategies,” says Chad Burlingame, director of alternative investments at U.S. Bank Wealth Management. “This is in contrast to the overwhelming trend in more conventional types of investments, where passive management vehicles such as index funds have become popular.”

Alternative investments can sometimes carry higher risk due to the types of investments included in their portfolios. However, as an investment category, alternatives have proven beneficial to many individual and institutional investors.

What is the difference between alternatives and traditional investments?

As stated previously, traditional investments tend to include stocks, bonds, and cash. Alternatives include a wide range of other investments, among them private equity, private debt and hedge funds. In comparing alternatives to traditional investments, here are some of the major distinguishing factors:

• Limited regulation. Alternative investments are not subject to the same level of regulatory scrutiny when compared to investments such as publicly-traded stocks, bonds or mutual funds.
• Investment qualification requirements. Most alternatives require potential investors to meet Accredited Investor, Qualified Client and/or Qualified Purchaser standards to invest. Definitions of standards are provided below. Even if those requirements are met, these products are not suitable for every investor.
• Illiquidity. Private market investments often require a commitment of seven-to-12 years. In addition, there’s no secondary market for these investments. In certain circumstances, investors may be allowed (with the approval of the general partner of the investment) to sell their interest, typically at a significant discount. Hedge funds may offer the potential to redeem shares, but usually no more frequently than semi-annually, often requiring three-to-six months’ notice from the investor. A redemption penalty may apply. It’s also notable that alternatives are not priced as frequently as traditional investments. “This may be a benefit for many investors, as they will be less inclined to react to price changes and derail a long-term investment strategy by moving money out of their investment,” says Burlingame.
• The use of leverage. Alternative investments may use borrowed capital (leverage) in an attempt to enhance returns. Most traditional investments, such as mutual funds, do not have as much flexibility to use leveraging strategies. However, it adds a degree of risk to alternatives as leveraged capital, while designed to magnify potential gains, also subjects the investor to potentially increased losses.
• Greater investment flexibility. The tools available to managers of alternative investments offer more opportunities to enhance returns. “A hedge fund manager, for example, can short a security (anticipating the security will lose value) as a way to boost returns,” says Burlingame. “This option isn’t available in most traditional managed investments.”
• Limited transparency. Because alternatives are not publicly traded, management firms do not have the same reporting requirements that apply to traditional investments. 

Benefits of alternative investments

The primary potential benefit of including alternatives is to create a more broadly diversified portfolio. Because many alternatives have the potential to generate returns that aren’t correlated with traditional investments, it creates an opportunity for smoother portfolio performance over time.

The potential for return enhancement is also a reason to consider these non-traditional investments. “Private market equity and debt portfolios may be the best opportunities for investors to capture returns that aren’t readily available in traditional investments,” says Haworth. “It adds another tool to the investor’s toolbox.”

Alternative investment strategies

There are several different types of alternative investments. Here are two of the most popular:

1. Private market investments

Consider private markets as the alternative investing counterpart of publicly traded stocks. Unlike stocks and bonds, however, when a business seeks private investors, only accredited or qualified individuals may invest. Successful private market investments have historically shown the ability to outperform their public market proxies.² There are three broad categories of private market investments:

• Private equity. There are different types of private market equity funds. They may be a part of a venture capital initiative, investing in start-up firms. Other private market investment teams are focused on implementing changes in existing firms, such as increasing revenues, cutting costs, or instituting changes among executive decision-makers. In either case, the goal is to generate a higher value that results in a profit when the fund sells its position.
• Private debt. These funds lend money to companies that are often unable to access capital from more traditional sources such as banks. The benefit for investors is that these loans can generate a competitive yield that may outpace those from traditional debt securities.
• Private real estate. These are professionally managed pooled private and public investments in the real estate market. It seeks to generate returns from the acquisition, financing and ownership of properties.

Typically, seeking a worthwhile investment in this area requires familiarity with a given sector. You may want to consider tapping into a network of investors and advisors to help source solid private market opportunities.

2. Hedge funds

Hedge funds are investments that use pooled funds with the goal of achieving significant return potential. Hedge funds mostly consist of stocks and bonds, in addition to currency and futures markets. They often use shortening strategies and leverage to enhance returns or manage risk.

Because of the inherent risk associated with hedge funds, most are only appropriate for accredited/qualified investors. Investors must have the ability to withstand the total loss of value of their investment.

Among the different hedge fund strategies are:

• Long-short equity and credit. These funds seek to profit both from price gains and price declines. They combine positions in stocks and bonds that are long (investing with an expectation of appreciation in value) and short (investing with an expectation of a decline in value).
• Event-driven. In some funds, managers seek opportunities through merger/arbitrage activity involving two or more companies. Some also incorporate activist strategies, attempting to initiate changes in management or corporate boards in an effort to unlock shareholder value.
• Distressed debt. These are obligations of companies that have or may soon file for bankruptcy. These debt securities can typically be purchased at a significant discount, with hopes that the firm can successfully restructure, and the bonds will greatly increase in value.

Get more details on how hedge funds work to diversify your portfolio.

Are alternative investments right for you?

If you meet qualification requirements to include alternative investments in your portfolio, there are additional issues to consider to determine whether they’re an appropriate fit. These include:

• Access to a growing marketplace. The alternative investment universe is growing, giving individual investors more access to a developing segment of the marketplace. “At the same time, the universe of publicly-traded securities is getting smaller,” says Burlingame. “Excluding alternative investments from a portfolio may be a missed opportunity for some investors.” Burlingame says alternatives allow investors to design a more customized portfolio to meet their long-term objectives.
• Investment objectives. Alternatives are typically appropriate for those with a long-term investment time horizon of seven-to-ten years or more. Even given a longer time horizon, there are challenges for individual investors. “Institutions that have successfully used alternatives have the benefit of a much longer time horizon than is the case for individual investors,” says Haworth. Individual investors need to have a willingness to lock money away for an extended period of time.
• Tax implications. Alternative funds are actively managed, which means there could be significant trading activity in the account. This has tax implications for investors in the form of short- and long-term capital gains. Also, tax reporting can be more complex than for traditional investments, complicating an individual’s annual tax filing process.

Work with your advisor

Alternative investments are not a “do-it-yourself” investment option. “The support of a financial professional is vital to gain access to this part of the market,” says Haworth. “You need to think through the complexities and costs and determine which types of alternatives are most suitable for your circumstances.”

Talk with your financial advisor to find out more about how alternative investments may be a consideration as you seek to meet your long-term investment objectives.