Understanding Alternative Investments: Complex and unregulated, alternative investments require significant investments, face valuation challenges, and have limited liquidity. Tax advantages exist, but high fees, lack of regulation, and complexity pose disadvantages.
Understanding Alternative Investments
Institutional investors or accredited, high-net-worth individuals hold the majority of alternative investment assets due to their complex nature, lack of regulation, and high level of risk. Alternative investments often require significant minimum investments and involve fee structures that are comparatively higher than those of mutual funds and exchange-traded funds (ETFs). Furthermore, alternative investments face challenges in providing verifiable performance data and advertising to potential investors. Despite the initial high minimums and upfront fees, alternative assets generally have lower transaction costs than traditional assets due to lower turnover rates.
Compared to conventional assets, alternative assets tend to have limited liquidity. Selling an 80-year old bottle of wine, for instance, is likely to be much more challenging than selling 1,000 shares of Apple Inc. due to the scarcity of buyers. Additionally, valuing alternative investments can be problematic as these assets and their associated transactions are often rare. For example, determining the value of a 1933 Saint-Gaudens Double Eagle $20 gold coin can pose difficulties for the seller since there are only 11 known to exist, and only one can be legally owned.
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Different Types of Alternative Investments
Peer-to-Peer Lending
Peer-to-peer lending involves the act of providing loans to individuals or businesses through online platforms that connect borrowers with investors. This type of lending closely resembles investing in bonds, but it operates within more private markets and often involves transactions with higher-risk clients, which in turn offers the potential for greater rewards.
Real Estate
Investing in real estate entails the allocation of funds towards physical properties or property-related securities like real estate investment trusts (REITs), real estate mutual funds, or crowdfunding platforms. Apart from seeking capital appreciation in tangible assets, investors aim to generate operating income that can offer consistent, ongoing cash flow.
Cryptocurrencies
Cryptocurrency, an emerging type of digital currency, is considered an alternative investment that falls beyond the conventional realm of stocks and bonds. While some argue that cryptocurrency may not serve as a robust hedge against other risk-on investments, it does have the potential for capital appreciation and the generation of passive income through staking rewards.
Farmland
Farmland serves as an alternative investment that combines elements of real estate and commodities. Investors have the option to allocate their funds to farmland, allowing them to benefit from the tangible and physical nature of the land itself. Moreover, farm owners may receive continuous cash proceeds if agricultural operations and the sales of commodities generate positive results.
Art and Collectibles
Certain investments can also serve as hobbies, such as art, sports memorabilia, entertainment memorabilia, or other collectibles, which can be considered alternative investments. These items may possess historical value or appreciate in worth over time as the associated parties, such as the artist, movie star, or athlete, gain increased significance.
Commodities
Commodities encompass raw materials like gold, silver, oil, or agricultural products. Investors have the opportunity to invest in these physical goods that possess tangible value and are consistently in demand due to their inherent qualities. For instance, the price of gold tends to be relatively stable since it finds extensive utilisation in various industries.
Venture Capital/Private Equity
Venture capital and private equity, while distinct from traditional stock investments, can be seen as a specialised extension of such investments. Rather than trading shares of publicly listed companies on open markets, investors explore alternative avenues to allocate capital towards privately-held companies or start-ups.
Regulation of Alternative Investments
Alternative investments, even if they don’t involve unique items like coins or art, are susceptible to investment scams and fraudulent activities due to the relative lack of regulatory oversight.
Compared to conventional investments, alternative investments often operate within a less clearly defined legal framework. While they do fall under the purview of the Dodd-Frank Wall Street Reform and Consumer Protection Act, their regulatory practices are subject to scrutiny by the U.S. Securities and Exchange Commission (SEC).
However, alternative investments typically do not require registration with the SEC. Consequently, they lack the same level of oversight and regulation as mutual funds and ETFs, which are under the SEC’s jurisdiction.
Therefore, it is crucial for investors to exercise thorough due diligence when considering alternative investments. In some cases, only accredited investors are allowed to invest in alternative offerings. Accredited investors are individuals with a net worth exceeding $1 million (excluding their primary residence) or an annual income of at least $200,000 (or $300,000 combined with a spousal income). Financial professionals holding a FINRA Series 7, 65, or 82 license may also qualify as accredited investors.
Advantages and Disadvantages of Alternative Investments
Pros of Alternative Investments
Diversification
As we understand, diversification plays a vital role in creating a well-rounded investment portfolio, and alternative assets can contribute to achieving a desired level of diversification. By incorporating alternative assets into your portfolio, you can enhance diversification and mitigate overall risk. This ensures that if one asset class experiences a decline, the impact on the portfolio as a whole will be minimised.
Higher Returns
Alternative investments offer an additional benefit of the potential to yield higher returns compared to traditional investing. Nevertheless, investors must exercise caution regarding the associated risks, as certain alternative investments entail a substantial level of risk in order to attain those higher returns.
May Not Correlate With the Stock Market
The stock market exhibits constant fluctuations, making it impossible to predict its next moves. In contrast, alternative investments may have little to no correlation with the stock market, enabling them to potentially rise even when the stock market is experiencing a decline. This non-correlation feature offers the advantage of diversifying a portfolio and shielding it from market volatility.
Tax Advantages
Certain alternative investments provide tax benefits that may not be available with other assets. For instance, specific forms of real estate investing allow for the deduction of certain expenses during tax season. This presents an opportunity to potentially reduce your tax burden by investing in select alternative real estate asset classes.
Cons of Alternative Investments
Illiquidity
Illiquidity is a characteristic commonly associated with alternative investments, as they often take the form of private rather than public investments. Consequently, alternative investments tend to have reduced liquidity, with exit options that can range from monthly to more than 12 years. This means that these investments can be challenging to divest, and your funds may remain tied up for an extended duration.
Lack of Regulation
Alternative investments lack regulation and are exempt from reporting requirements. Furthermore, valuing the underlying assets of alternative investments presents challenges, resulting in difficulties in determining their prices and maintaining price transparency.
High Minimum Investments
Numerous alternative investments have substantial minimum investment requirements, making them inaccessible to a wide range of investors. Moreover, alternative investments typically entail higher fees compared to other investment options.
Complexity
Alternative investments frequently involve intricate structures and may necessitate a more thorough level of due diligence. When contemplating alternative investments, it is crucial to conduct thorough research and comprehend the potential tax implications associated with them.
FAQs
What makes an investment an alternative investment?
Alternative investments encompass financial assets that fall outside the conventional classifications of equity, income, or cash. They encompass various forms such as private equity, venture capital, hedge funds, real estate, commodities, and tangible assets.
Are alternative investments regulated?
Alternative investments, also known as alternative assets, tend to be illiquid in nature, which implies that they cannot be readily sold or converted into cash. Additionally, these investments are frequently unregulated by the U.S. Securities and Exchange Commission (SEC) or other governing bodies.
Do alternative investments have higher returns?
Alternative investments encompass a diverse array of assets and strategies, yet they are typically distinguished by two key features: First, they exhibit a low correlation with traditional investments such as stocks and bonds. Second, they offer a higher potential for returns compared to traditional investments.
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