Alternative Investments

Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

Alternative Investments Definition

Alternative investments refer to investments made in assets classified as non-traditional investment vehicles. It is meant for investors who wish to have a diversified portfolio with increased returns. While traditional or conventional forms for investments are open for all kinds of investors, alternative investments opportunities are confined to wealthy investors, like high-net-worth individuals (HNWIs).

Alternative investments

These non-conventional investments involve dealing in assets other than the widely invested-in individual stocks, bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more, and commoditiesCommoditiesA commodity refers to a good convertible into another product or service of more value through trade and commerce activities. It serves as an input or raw material for the manufacturing and production units.read more. With different types of options available, investors get a chance to build their portfolios by spending on securities that could help them build a better investment base.

Key Takeaways

  • Alternative investments include types of investments made in assets that do not fall under the traditional investment category.
  • Alternative investments management is more active, ensuring constant monitoring and recalibration of investment strategies given the complexities involved.
  • These investments are classified into tangible (assets that could be touched) and intangible (assets that could not be touched but carry value).
  • The valuation of the asset classes involved is complicated as these investments require specific knowledge and skills to be handled.

Alternative Investments Explained

Alternative investments, as a domain, are still evolving and maturing. While it is mainly considered a prerogative of the HNWI investors, some retail investors also show a keen interest in investing in these asset classesAsset ClassesAssets are classified into various classes based on their type, purpose, or the basis of return or markets. Fixed assets, equity (equity investments, equity-linked savings schemes), real estate, commodities (gold, silver, bronze), cash and cash equivalents, derivatives (equity, bonds, debt), and alternative investments such as hedge funds and bitcoins are examples.read more. After the financial crisisFinancial CrisisThe term "financial crisis" refers to a situation in which the market's key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.read more in 2008, where even the best of the diversified portfolios were swayed by extreme volatility, these non-traditional investments managed to prove their worth.

These investments differ from traditional investments in terms of complexity, liquidityLiquidityLiquidity is the ease of converting assets or securities into cash.read more, regulatory mechanism, and mode of fund managementFund ManagementFund management is the process of a company taking a person's, company's, or another fund management company's financial assets (generally high net worth individuals) and investing them in companies that use those funds as an operational investment, financial investment, or any other investment in order to grow the fund.read more. These asset classes usually have a market correlation between -1 to 0, making them less susceptible to market-oriented or systematic riskSystematic RiskSystematic Risk is defined as the risk that is inherent to the entire market or the whole market segment as it affects the economy as a whole and cannot be diversified away and thus is also known as an “undiversifiable risk” or “market risk” or even “volatility risk”.read more elements.

Alternative Investments

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The non-traditional investments offer better diversification benefits with enhanced returns. When a stock or bond underperforms, a hedge fundHedge FundA hedge fund is an aggressively invested portfolio made through pooling of various investors and institutional investor’s fund. It supports various assets providing high returns in exchange for higher risk through multiple risk management and hedging techniques.read more or private equityPrivate EquityPrivate equity (PE) refers to a financing approach where companies acquire funds from firms or accredited investors instead of stock marketsread more firm can make up for the extent of losses over the long term. In addition, one can add or replace alternative assets based on individual investment goals and risk appetiteRisk AppetiteRisk appetite refers to the amount, rate, or percentage of risk that an individual or organization (as determined by the Board of Directors or management) is willing to accept in exchange for its plan, objectives, and innovation.read more.

These investments call for the active management of funds. The complexities involved with respect to the nature of the assets, volatility, and elevated risk level make constant monitoring and recalibration of investment strategiesInvestment StrategiesInvestment strategies assist investors in determining where and how to invest based on their expected return, risk appetite, corpus amount, holding period, retirement age, industry of choice, and so on.read more a must. In addition, the valuation of these non-conventional asset classes is complicated as these investments require specific knowledge and skills to be handled. Plus, the assets belonging to this category are unique, making accurate valuation difficult.

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Types of Alternative Investments

Alternative investments are available in two broad categories – Tangible and Intangible.

#1 – Tangible Investments

These are the alternative investments types meant for assets having a physical existence. When an investor spends on a real assetReal AssetReal Assets are tangible assets that have an inherent value due to their physical attributes. These assets include metals, commodities, land, and factory, building, and infrastructure assets. read more, personal property, or hard assetHard AssetHard assets refer to physical or tangible items that can be touched and felt. An individual or company can possess such assets for long term usage with an expectation of value appreciation in future.read more, it is considered a tangible investment. Some of these assets are evaluated on their appreciation ability, while the rest are held on their ability to generate income as they depreciate. For example, collectibles have good appreciation value, and hence they are judged in accordance with that. On the other hand, equipment taken on leaseLeaseLeasing is an arrangement in which the asset's right is transferred to another person without transferring the ownership. In simple terms, it means giving the asset on hire or rent. The person who gives the asset is “Lessor,” the person who takes the asset on rent is “Lessee.”read more is evaluated depending on their level of depreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. read more. Some of the examples of assetsExamples Of AssetsExamples of assets include all current, capital and intangible assets owned by a company and used for accounting purpose. Some of these are cash, accounts receivable, building, plant and equipment, goodwill and patents.read more are as follows:

Precious Metals/Commodities

Not all investments are towards businesses or a pool of funds. Some of them are towards real assets like precious metals or natural resources. Investing in grains, gold, silver, or other precious metals has been preferred for ages, and they continue to be the best hedgeHedgeHedge refers to an investment strategy that protects traders against potential losses due to unforeseen price fluctuations in an assetread more against market movements and currency fluctuations. Investors can invest in gold either through gold coins, bullions, or indirectly through sector traded funds or exchange-traded fundsExchange-traded FundsAn exchange-traded fund (ETF) is a security that contains many types of securities such as bonds, stocks, commodities, and so on, and that trades on the exchange like a stock, with the price fluctuating many times throughout the day when the exchange-traded fund is bought and sold on the exchange.read more.

Real estate

Real estate is yet another effective alternative investment for investors. Investing in plots, houses, and reaping rental yields or commercial assets are some of the direct ways of investing in real estate. Investors, however, can also invest in real estate indirectly through Real Estate Investment Trusts (REITs). This type of investmentType Of InvestmentStocks, bonds, and cash equivalents are the three main forms of investments. Investment, in general, refers to the purchase of anything for future use with the goal of generating a regular cash flow or increasing the value of something over time so that it can be sold for a higher price than it was purchased for, i.e. capital gains. read more is driven by the low co-relationship between equity marketsEquity MarketsAn equity market is a platform that enables the companies to issue their securities to the investors; it also facilitates the further exchange of these stocks between the buyers and sellers. It comprises various stock exchanges like New York Stock Exchange (NYSE).read more and real estate that helps in ideal hedgingHedgingHedging is a type of investment that works like insurance and protects you from any financial losses. Hedging is achieved by taking the opposing position in the market.read more against inflation.

Collectibles

Stamps, artwork, and vintage wine are normally considered mere prestigious souvenirs. However, they are highly valuable assets for investors who are aware of how profitable these collectibles are to invest in. Coins, art, and stamps are asset classes preferred for such tangible alternative investments.

Alternative investments Types

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#2 – Intangible Investments

Intangible investment is made in assets that cannot be seen or checked, but the status and value of which could be monitored and assessed based on their market performance. Some of the asset classes that belong to these alternative investments types include:

Hedge funds

Hedge funds are alternative investment vehicles catering to investors with ultra-deep pockets. In the United States, hedge funds are considered accredited investors’ options. As a result, they are not regulated as mutual fundsMutual FundsA mutual fund is a professionally managed investment product in which a pool of money from a group of investors is invested across assets such as equities, bonds, etcread more and give investors leeway to invest in a broader range of securities. One thing that distinguishes hedge funds from other alternative investments is their liquidity quotient. These funds can sell off in minutes due to their increased exposure to liquid securities.

Private equity

The equities not listed on stock exchangesStock ExchangesStock exchange refers to a market that facilitates the buying and selling of listed securities such as public company stocks, exchange-traded funds, debt instruments, options, etc., as per the standard regulations and guidelines—for instance, NYSE and NASDAQ.read more fall under the private equity label. These are funds that institutional investorsInstitutional InvestorsInstitutional investors are entities that pool money from a variety of investors and individuals to create a large sum that is then handed to investment managers who invest it in a variety of assets, shares, and securities. Banks, NBFCs, mutual funds, pension funds, and hedge funds are all examples.read more or HNWIs directly place in private companies or use in the buyoutBuyoutA buyout is a process of acquiring a controlling interest in a company, either via out-and-out purchase or through the purchase of controlling equity interest. The underlying principle is that the acquirer believes that the target company’s assets are undervalued.read more of public companies. The firms, in turn, utilize the capital for their inorganic and organic growthOrganic GrowthOrganic growth is the rate of growth that a company achieves by increasing sales revenue by increasing volume of products sold or by achieving greater operational efficiency leading to a reduction in the cost of production or any other internal improvement.read more while expanding their footprint, increasing marketing operations, technological advancement, and making strategic acquisitionsAcquisitionsAcquisition refers to the strategic move of one company buying another company by acquiring major stakes of the firm. Usually, companies acquire an existing business to share its customer base, operations and market presence. It is one of the popular ways of business expansion.read more.

Venture capital

Venture capital refers to the type of investment where investors spend on equityEquityEquity refers to investor’s ownership of a company representing the amount they would receive after liquidating assets and paying off the liabilities and debts. It is the difference between the assets and liabilities shown on a company's balance sheet.read more capital in private startups, having exceptional potential for growth. The concept might sound similar to the private equity concept, but it’s not as it invests equity capital into mature companies. Venture capitalists usually invest in seed and early-stage businesses, while some invest at the expansion stage. The investment horizonInvestment HorizonThe term "investment horizon" refers to the amount of time an investor is expected to hold an investment portfolio or a security before selling it. Depending on the need for funds and risk appetite, the investor may invest for a few days or hours to a few years or decades.read more is typically between 3-7 years. The expected returnExpected ReturnThe Expected Return formula is determined by applying all the Investments portfolio weights with their respective returns and doing the total of results. Expected return = (p1 * r1) + (p2 * r2) + ………… + (pn * rn), where, pi = Probability of each return and ri = Rate of return with probability. read more rate is quite high, which is a natural outcome owing to the risk quotient associated with the investment.

Cryptocurrency

The Generally Accepted Accounting Principles (GAAP)Generally Accepted Accounting Principles (GAAP)GAAP (Generally Accepted Accounting Principles) are standardized guidelines for accounting and financial reporting.read more consider cryptocurrencyCryptocurrencyCryptocurrency refers to a technology that acts as a medium for facilitating the conduct of different financial transactions which are safe and secure. It is one of the tradable digital forms of money, allowing the person to send or receive the money from the other party without any help of the third party service.read more an intangible assetIntangible AssetIntangible Assets are the identifiable assets which do not have a physical existence, i.e., you can't touch them, like goodwill, patents, copyrights, & franchise etc. They are considered as long-term or long-living assets as the Company utilizes them for over a year. read more. These currencies are recorded at acquisition cost, which is either the price paid or the cost considered. Plus, their impairment cost is also observed and recorded after proper testing and evaluation. According to Forbes, the value of the cryptocurrency can be reduced over time while recorded in a balance sheet.

Alternative Investment Strategies

Formulating strategies to crack the best investment deals is a must. As traditional investment options are widely available, the data and information available on assets are accessible. Thus, framing effective traditional investment strategies becomes easier. 

On the other hand, alternative investments, which involve only accredited investorsAccredited InvestorsAccredited investor refers to a person who has been granted special status under financial regulation laws, allowing him to trade in securities that have not been registered with the regulatory authorities, and it usually involves high-net-worth individuals, brokers, trusts, banks, and insurance companies.read more to invest in the assets and securities, make available very limited information. Thus, the formulation of alternative investments strategies rests on the shoulders of fund managers, who remain updated and keep on studying the current and historical market trends.

While framing strategies to deal with alternative funds, there are a few things that need careful consideration:

  • The United States Securities and Exchange Commission (SEC) does not regulate these investments.
  • They possess a low liquidity rate, which means they are tough to sell or convert to cash.
  • They are less correlated to the market. It means the prices do not move in the same direction as the market. In short, these are less volatile investments.

Examples

Let’s consider the following alternative investments examples to understand the type of them available in the market:

Example #1

HNWI Sarah began her search for an asset that would remain unaffected even if the market fluctuates. She consulted a stock advisor, Joe. He advised her not to go for traditional paper assets, like individual stocks or bonds. Rather, he suggested opting for commodities like oil, grain, gold, other metals, and natural gas less affected by the negative market movements. In addition, he told Sarah that investing in tangible commodities will mean having a shield against loss. Thus, the investor followed Joe’s advice and invested at least 5% of the portfolio in tangible investments.

Example #2

The private equity industry has been out of regulatory supervision since its birth in the 1940s. However, after the 2008 financial crisis, it has been labeled under the purview of the Dodd-Frank Wall Street Reform and Consumer Protection Act. In addition, there has been an increased call for transparency in recent times, and the US Securities and Exchange Commission (SEC) has started collecting data on private equity firms.

Frequently Asked Questions (FAQs)

What are alternative investments?

Alternative investments are investments specifically meant for accredited investors who are wealthier than normal retail investors. Such investments are made in assets that do not fall under traditional asset classes, like individual stocks, bonds, etc. The lower market correlation makes these investments less volatile, and hence these turn out to be a hedge against inflation for investors.
These non-conventional investments are classified as tangible (real estate, precious metals, commodities, etc.) and intangible (private equity, hedge funds, cryptocurrency, etc.).  

Are ETFs alternative investments?

The exchange-traded funds or ETFs are investments that fall between alternative and traditional investments. It lets investors enjoy alternative investment opportunities while not facing any illiquidity issues. In addition, unlike other alt funds, ETFs are well-regulated and could be easily managed, sold, and converted to cash.

What are the differences between alternative and traditional investments?

The differences between alternative and traditional investments are:
Alternative Investment Difference

This has been a Guide to Alternative Investments Definition and Features. Here we discuss Alternative Investments types, strategies with real-life examples. You may also learn more about financing from the following articles –

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Comments

  1. Preston fernandes says

    Thanks for sharing this informative blog. Sir I have one small question, I would be glad if you can answer this. Sir is it good to choose Investment banking as a career, I mean how does an investment bankers life be, is it good or bad. All through the point I just want to know how is the life of Investment banker?

    • Dheeraj Vaidya says

      Hi Preston, tough question. Is investment banking good or bad? It is good for those who love finance and don’t have problems with spending 14-18 hours a day in office. Those who enter this entry because they think that it is “yo”, then they quit this industry very soon.

  2. Nolan kowells says

    Thanks for the information. I am interested in learning investment banking. I have gone through many websites but didn’t find anything useful. Do have any study material through which I can prefer to learn investment banking. Please share me any detail if you have regarding this.