Alternative investments are not a new concept. But in recent years, the interest in “alts” has skyrocketed. What was once an asset class reserved for the super-wealthy, alternatives have boomed in popularity among mass market investors, partly due to the increase in accessibility that technology now provides us to investment vehicles like ETFs and mutual funds.
Before deciding if alternatives are right for your portfolio, it is important to learn the basics, pros and cons to this unconventional investment type.
What are alternative investments?
Put simply, an alternative is an asset that is not one of the conventional investment types, such as stocks, bonds or cash. Some alternatives are widely used and traditional, while others are more obscure to the general audience – such as marijuana, stamp collections or even the lottery! The 4 main groups include:
- Hedge Funds: A fund that pools capital from accredited individuals or institutional investors and invests in a variety of assets.
- Private Equity: Shares that represent ownership of or an interest in an entity that is not publicly listed or traded.
- Real Assets: Tangible investments such as real estate, commodities (gold, marijuana, energy), vehicles, or valuable art or stamp collections.
- Structured Products: More complex in nature, these products offer investors the potential to earn returns tied to the performance of an index or basket of securities.
So, why are alternatives becoming increasingly popular asset classes? Overall, alternatives have the potential to reduce an investor’s risk by diversifying their portfolio. And when it is managed properly, investors can see an increased return on their investment through alpha – or in other words, having an edge on the market. Lastly, alternatives open the possibility to new investment opportunities that otherwise would not be available through traditional stocks and bonds.
Understanding the Risks
As with any asset class, alternatives have many distinct characteristics that are important to consider before deciding if they are right for your portfolio. The short-list includes:
- An increased risk of loss: Alternatives can be more variable than stocks and bonds. Remember that each alternative operates differently, so the risk must be evaluated on a case-by-case basis.
- Limited liquidity: Liquidity – or the degree to which an asset or security can be quickly bought or sold in the market without affecting the asset’s price – is a common concern with alternative investments. Remember that real assets, such as real estate or automobiles, must go through an appraisal process before being liquidated, which can take time.
- Complexity and unpredictability: Each investment is entirely unique and can drastically range in terms of complexity and volatility. As a rule of thumb, I tell my clients that they should never invest in anything they do not fully understand.
- Capital calls and lock-up periods: These terms are important because they indicate if and when an investor is able to liquidate and collect their assets, and how much. Have your advisor show you these terms, on paper, before investing. Otherwise, in the case of an emergency, you may be surprised to find your assets inaccessible.
- Due diligence: Certain investments require time- and cost-intensive due diligence, such as real estate. This should be calculated into the cost of the investment.
- Legal restrictions: Also consider the potential legal and advising fees associated with certain investments. Is the return worth the cost?
- Variable performance reporting patterns: You may find that your alternatives are assessed during a different time frame than stocks and bonds.
The Final Say
As the marketplace continues to evolve, we anticipate a prolonged “alts boom” as investments such as blockchain, marijuana and real estate continue to make news headlines, and access to vehicles like ETFs and mutual funds are at the click of our smart phones. However, just like any investment, it is important to consider all of the pros and cons. I will leave you with my 3 Golden Rules of Alternative Investing:
- If you do not understand the investment, do not invest.
- There will never be a situation where you must invest within 24 hours. Always complete the proper due diligence before making an investment decision.
- Always know where your money is, and how quickly you can access it.
For further learning on alternative investments, be sure to read this article, “Use these investments to ride out market volatility, but beware the risks,” on CNBC by Lorie Konish where I was mentioned or send me your questions on alternative investments.
Mark S. Germain, CFP®, MBA, ADPA® is CEO and Founder of Beacon Wealth Management. Contact him at firstname.lastname@example.org or by telephone at 201-447-9500.