What is an ‘Alternative Investment’
An alternative investment is an asset that is not one of the conventional investment types, such as stocks, bonds and cash. Most alternative investment assets are held by institutional investors or accredited, high-net-worth individuals because of the complex natures and limited regulations of the investments. Alternative investments include private equity, hedge funds, managed futures, real estate, commodities and derivatives contracts.
BREAKING DOWN ‘Alternative Investment’
Many alternative investments have high minimum investments and fee structures compared to mutual funds and exchange-traded funds (ETFs). There is also less opportunity to publish verifiable performance data and advertise to potential investors. Most alternative assets have low liquidity compared to conventional assets. 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, due to a limited number of buyers.
Investors may have difficulty valuing alternative investments due to transactions often being unique. For example, a seller of the extremely rare 1933 Double Eagle $20 gold coin may have difficulty determining its value, as there are only 13 known to exist as of 2016. Alternative investments are prone to investment scams and fraud due to their unregulated nature, therefore it is essential that investors conduct extensive due diligence.
Alternative Investments for Diversification and Hedging
Alternative investments typically have a low correlation with those of standard asset classes, which makes them suitable for portfolio diversification. Because of this, many large institutional funds such as pensions and private endowments have begun to allocate a small portion of their portfolios, typically less than 10%, to alternative investments such as hedge funds. Investments in hard assets such as gold and oil also provide an effective hedge against rising inflation, as they are negatively correlated with the performance of stocks and bonds.
Alternative Investment Costs and Tax Considerations
Although alternative assets may have high initial upfront investment fees, transaction costs are typically lower compared to conventional assets, due to lower levels of turnover. Alternative investments held over a long period of time may result in tax benefits, as investments held longer than 12 months are subject to a lower capital gains tax in comparison to shorter-term investments.
Accessing Alternative Investments Through ETFs
While the majority of retail investors may have limited availability to alternative investment opportunities, real estate and commodities such as precious metals are widely available. ETFs now provide ample opportunity to invest in alternative asset categories that were previously difficult and costly for the retail investor to access. Investing in ETFs that have exposure to alternative assets has been mixed. As of February 2018, the SPDR Dow Jones Global Real Estate ETF had an annualized five-year return of 4.6%, while the SPDR S&P Oil & Gas Exploration & Production ETF returned negative 7.7% for the same period.
Regulation of Alternative Investments
Alternatives investments are often subject to a less clear legal structure than common investments but are increasingly regulated by the Dodd-Frank Wall Street Reform and Protection Act. They are still not overseen, however, as closely as mutual funds and ETFs by the Securities and Exchange Commission (SEC) and the Financial Industry Regulation Commission. Often, only those deemed “accredited investors” (those with a net worth exceeding $1 million or with a personal income of $200,000 or more per year) have access to alternative investment offerings.