Understanding Alternatives

Posted: Aug. 16, 2017, 11:33 a.m. by

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Alternatives, also known as alternative investments, are assets that are not stocks, bonds or cash – in other words they are not traditional investment vehicles. The majority of alternative investments are made and held by institutional investors or accredited, high-net-worth individuals.

This is because alternatives are complicated, have high minimum investments and fees and regulation is minimal. They are also illiquid or much more so than stocks and bonds. Typical alternatives include private equity, hedge funds, managed futures, real estate, commodities and derivatives. Certain collectible items can also be alternative investments.

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Why Alternatives Are Desirable

Alternatives have a low correlation with standard assets (like stocks and bonds). This makes them highly desirable to provide for portfolio diversification. Certain alternatives such as gold and oil can also be a hedge against rising inflation.

Transaction costs for alternatives are typically lower than with conventional assets – mostly because alternatives have lower levels of turnover. When you hold alternatives over a long time period, you might gain tax benefits due to lower capital gains taxes on assets held longer than 12 months.

One Way To Get There - ETFs

If you are not an institutional investor or high-net-worth individual, your access to alternatives will be limited. One way to invest in alternatives like real estate and commodities is through widely available ETFs.

Be aware that the performance of alternative-based ETFs has been mixed. As of June 2016, real estate ETFs had a 5-year annualized return of 9.42%. ETFs that invested in energy commodities posted a negative 21.27% return. Over the same period the S&P 500 index ETF had an 11.67% return.

Alternatives In Your IRA

IRAs are not restricted to traditional investments which makes them ideal for alternative investments – provided you follow the rules. One rule is no life insurance and no collectibles (although certain gold and silver coins are OK). There are other prohibited transactions designed to prevent you from using IRA funds to engage in self-dealing.

Permitted alternatives include stock from an IPO, closely held stock, real estate, options on real estate, oil and gas royalty interests, stock options and mortgages or loans held for investment.

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The Role Of Technology

Technology has made it possible for retail investors (who are accredited, high-net-worth) to directly access and invest in alternatives. Platforms like Darcmatter typify this type of investment vehicle.

Among investments currently available to retail investors: Private equity invests in private companies. Direct investments can also be aimed at private companies and startups. A subset of private equity investing is called venture capital, which invests in early-stage and growth-stage companies. Real assets are physical or tangible assets that have value. These include real estate, commodities and farmland to name just a few. Hedge funds pool investments funds and invest in a variety of strategies and asset types. Private placement debt is an asset class that has grown in the alternatives space. Private placement bonds are not issued publicly – hence the name private – and are not required to be rated by a credit rating agency. Finally, there are fund of funds, large vehicles that form funds to invest in other alternative investment funds.