Understanding the Pros and Cons of Alternative Investments

Once the domain of institutional and high-net-worth investors, alternative investments continue to grow in popularity and are making their way into the portfolios of retail (individual) investors.

The term is a catchall for any assets that are bought and sold outside the major stock, bond, and commodity markets. Alternative investments can mean anything from investment-worthy antiques to bitcoins. It also covers undertakings like private equity deals and venture capital firms.

Alternative investments have their allure, particularly to high-net-worth individuals who have a special interest (and expertise) in an esoteric subject and believe they can turn that interest into a valuable investment.

Here are some of the pros and cons of alternative investments.

Benefits of Alternative Investments

Alternative investments typically don’t correlate to the stock market, which means they can be used to add diversification to a portfolio and help mitigate volatility. Some can also offer tax benefits not available in traditional investments.

Like any investment, the rate of return for alternatives is not guaranteed, but there is potential for it to be higher than that of traditional investments.

Proponents of alternatives in the portfolios of individual investors maintain they now have access to sophisticated investments and potentially higher returns that until relatively recently were only available to institutions, such as pension funds and foundations.

Understanding the Risks of Alternative Investments

Alternative investments are more complex than traditional investment vehicles. They often have higher fees associated with them.

As with any investment, the potential for a higher return means higher risk.

Strategies to Mitigate Risks in Alternative Investments

Alternative investments have proliferated since the financial crisis in 2008, especially those alternatives that are more liquid.

At its broadest definition, alternative investments can include some exchange-traded funds (ETFs) and mutual funds that use strategies similar to hedge funds to mitigate risk. In other words, their portfolios are so diverse that their overall returns are not correlated to the stock market or the bond market.

Alternative investments such as private equity stakes are even making their way onto 401(k) portfolios. The underlying assets of private equity funds are generally illiquid and difficult to value, which creates a challenge when offering them in defined contribution plans. Defined contribution plans provide liquidity and prices daily on investment options offered to plan participants. To overcome liquidity and pricing challenges, private equity firms are looking to offer private equity exposure via target-date funds and collective investment trusts.

Advocates of private equity as an option in 401(k) plans maintain that the average investor will now have access to the potentially higher returns that this type of non-traditional investment yields compared to the typical plain-vanilla options—like mutual funds and stock and bonds—from which they have to choose.

Future Trends in Alternative Investments

The overall market for alternative investments could grow to $14 trillion by 2023, according to a report by Preqin, a data intelligence provider. Its report defines hedge funds and private equity as classes of alternative investments.

Part of the reason for this may be that investment firms have lowered the entry requirements for mutual funds that are oriented toward alternatives. Also, investors themselves have developed a taste for something besides the usual mix of bonds, mutual funds, and exchange-traded funds.

Many emerging economies are switching from a savings-oriented approach to an investment approach, making themselves attractive to investors seeking new opportunities.

However, this outlook may be conservative considering the arrival of investing in cryptocurrencies such as bitcoin. This investment option could falter, but the amount of interest in it from institutions worldwide suggests that it could be a viable alternative for those seeking high-risk/high-return vehicles.  

Another investment that is attracting a lot of money is equity crowdfunding. Individual investors can purchase shares of a new company through online sites that offer these opportunities.

This is a very high-risk investment because many new companies fail. But there are enough investor success stories to make this option attractive for even small investors.  

Final Considerations on Alternative Investments

Proponents of non-traditional investments maintain that the average investor now has access to assets not correlated to the stock market, offering diversification and potentially higher returns when compared to mutual funds, stocks, and bonds.

They also are more volatile than traditional investments such as stocks, bonds, and mutual funds. Most are relatively illiquid, meaning they are difficult to sell quickly.

Most of these alternatives are complex and often have higher risks than traditional investments.

A wise investor might see alternative investors as a means toward diversification rather than the central strategy of a long-term plan.