A Beginner’s Guide to Alternative Investments
AFTER A VOLATILE 2020 in traditional stock and bond markets, interest in alternative investments is growing.
That said, alternative investments are not for everyone. Access is limited to high-net-worth individuals and entities who are allowed to invest in securities that are not always registered with financial regulators. These investors usually fall into two groups: accredited investors and qualified purchasers.
Accredited investors must have an individual income exceeding $200,000 – or $300,000 for joint income – for the last two years and expect their earnings to continue at that level, or have an individual or joint net worth exceeding $1 million. Qualified investors have an investment portfolio of $5 million or more, individually or jointly. These people are considered to be sophisticated investors or have access to sophisticated information or advisors.
In October, the U.S. Securities and Exchange Commission expanded those definitions to also include specific educational requirements for people who work in the finance industry, says Keith Black, managing director of content strategy for CAIA Association, which offers investment professionals certification in alternative investments.
For example, Black says fund managers who might not meet the income or asset requirements can invest in their own funds. Financial professionals who pass certain exams from the Financial Industry Regulatory Authority, the government-authorized organization that oversees U.S. broker-dealers, also qualify.
What Are Alternative Investments?
Investors who want exposure to alternative assets seek investments outside of the traditional markets of stocks, fixed income or cash. The goal is to create portfolio diversification and to enhance returns, Black says. Historically, some alternative investments such as private equity or venture capital have had returns above public equity markets, he says.
Investing in alternative assets often requires buyers to lock up their money for five, maybe 10 years, says Joe McLean, managing partner of multifamily office Intersect Capital. During that time, investors may not see any money distributed. Liquidity is also an issue as fund managers can’t easily buy or sell holdings like managers in traditional markets, so investors can’t easily tap those assets when they want.
Many types of alternative asset classes aren’t correlated with stocks and are expected to perform best when equity returns are flat or down, Black says. Here are some common alternative investment types:
Private equity invests in non-publicly traded companies. Investors’ money can be unavailable for as long as 10 years as they wait for the private equity fund to sell the holdings in an initial public offering or sell to a strategic buyer or in a merger, Black says.
Transparency is an issue, as buyers often commit to investing in a blind pool and won’t know what the company is until the manager finds the investment.
[ READ: Sign up for stock news with our Invested newsletter. ]
Venture capital is a sub-category of private equity. It invests in early stage companies that have the potential for outsize growth, or are looking to expand rapidly in a new or innovative space. There’s a high chance for failure since many of these companies may not have revenues or profits yet, but there’s also high reward if a firm succeeds.
Private equity and venture capital may require investors to make capital calls, McLean says.
An investor may commit $200,000 to a fund, but the managers take money in $50,000 tranches over two years. If investors don’t have the earmarked funds available when the manager needs it, they can pay enormous penalties.
“You have to be prepared to have that built into your financial plan as if you’ve already invested the entire amount,” he says.
Just as some companies tap private equity for funding, some also look to private lenders, says Michael Harris, director of family office and partner with Verdence Capital Advisors. Private debt, sometimes called private credit, is also an opportunity for investors to possibly get higher yields compared to what’s available in public markets.
There are different types of private debt, including mezzanine and senior debt, considered to be higher on the payout structure in cases of default and considered less risky. Distressed credit is considered riskier since it invests in debt of companies under stress.
Many strategies around hedge funds attempt to offer some sort of return and to be a buffer when traditional assets fall. Harris notes there are 16 common types of hedge-fund strategies. One common strategy is long-short equity. Managers will invest in a company that has the potential to appreciate, but they may also sell short, or bet against the company and would profit if the value goes down. Hedge funds may use absolute return strategies, also known as “all-weather strategies,” investing in many different asset classes and strategies to generate returns no matter what traditional markets are doing.
A third common strategy is market neutral, Harris says. In addition to having more of a 50/50 long-short exposure in the portfolio, market neutral funds also attempt to reduce systematic risk created by factors such as exposures to sectors, market-cap ranges, investment styles, currencies or countries.
Real estate is considered an alternative asset when people buy investment property such as office buildings or residential apartments, says Sal Bruno, managing director and chief investment officer for IndexIQ, an exchange-traded fund provider with alternative asset ETFs. Investors who may not want to be landlords can use a broker to buy into private real estate investment trusts, or REITs. Publicly traded REITs are listed on stock exchanges.
“The public real estate investment trusts have some characteristics of real estate, but oftentimes are considered to be very equity-oriented,” Bruno says. That’s because they are traded on exchanges.
Harris says other private real estate investments include timberland and farmland.
Commodities are mostly natural resource investments, such as crude oil, corn and coffee. Being real assets, they are often considered an inflation hedge.
Commodity trades are implemented in the futures market, Bruno says, and have set times during the year when contracts mature.
Investors need to sell the contract ahead of maturity and buy a new one to hold the position. Sometimes the new contract is more expensive than the old contract, which can be a drag on performance.
“These roll issues are well documented,” he says.
Some commodity markets are also available through ETFs, such as gold or oil.
[ SEE: 9 Commodity ETFs to Buy Now. ]
Regulation of Alternative Investments
“Everyone in the market has the same rules: do not lie, do not cheat and do not steal, so they’re completely regulated in that way,” Black says.
But alternative investors differ from public markets, such as stocks, bonds and mutual funds, in key ways. Publicly traded investments fall under the 1940 Investment Act, which regulates investment funds. Two sections of that act describe accredited investors and qualified purchasers under private-placement exemptions. If a fund manager promises to only sell their fund to accredited and qualified purchasers, that’s a private-placement exemption from the act, so the rules don’t apply to that fund, Black says.
This exemption allows fund managers to use a maximum level of leverage or be very illiquid, and they don’t have to report a daily net asset value, regular holdings reports or a prospectus, for example. There’s not necessarily full disclosure, and that’s part of the point of these investments. These managers can cloak what they do, he says.
What investors receive in lieu of a prospectus is a private-placement memorandum of understanding, which dictates the fees, liquidity and the type of investment. “If you tell your investors that you’re a commodity fund, the SEC wants you to be a commodity fund. They don’t want it buying real estate,” Black says. “They have to follow the terms of those documents.”
Investors may get monthly or quarterly data, but it is often delayed. Black says as of early January, hedge-fund returns are current as of November and private-equity returns are current as of June.
Pros and Cons of Alternative Investments
Like any other investment, alternative investments come with pros and cons:
Pro: Diversification. Harris says the two big reasons to include alternative investments, portfolio diversification and to enhance returns, must be considered carefully. Alternative investments should have low correlation to traditional markets, but that doesn’t mean negative correlation, he says, which is a common mistake.
“Lowly correlated means, on the spectrum of a plus one to a negative one correlation, those funds are trying to get as close to zero as possible. It means that sometimes they’re going to move with traditional assets. And sometimes they will move in the opposite direction,” he says. “It’s not a promise that those alternative investments will always perform well when markets go down.”
Con: Long lock-ups. While alternative investments like private equity can enhance returns, it can mean locking up your investment money for 10 years, and that’s why investors need to seriously consider how much of a return premium they may get over the liquid public markets, Harris says.
Pro: Exposure to unique investments. Alternative investments allow people to access markets they won’t be able to otherwise access such as land or being an early investor in a startup fund, which can pay big returns for patient investors.
Con: Complexity. These are very complex investments that take serious due diligence. Professional investors such as Harris will spend a great deal of time researching strategies and interviewing managers. “The difference between the top quartile managers … and the bottom quartile is huge. In some cases, it can be 15 to 20 percentage points in a given year,” he says.
Fees can be high, McLean says. Historically, most alternative investments have an upfront fee of 2% annually and when the fund distributes the money, managers take 20% of the gains.
“If you’re going to be paying those excessive fees, which is what I would consider them, make sure that there’s a track record that shows the fund is outperforming the fees,” he says.
McLean says most people access alternative assets through an institution or their financial advisor, but newer digital platforms are starting to offer ways to buy directly. He says for new buyers it’s still best to invest with a professional who understands the asset class, its benefits and challenges.
“Liquid alts” are growing in popularity, Black says, such as mutual funds and ETFs that offer exposure to alternative investments. These regulated securities are available to anyone and offer daily liquidity, a prospectus and show their holdings. It’s not the same as direct alternative-asset ownership because of the restrictions placed on regulated securities such as limits on leverage and diversification. These can be an introduction to the space, but the expense ratios can be higher than traditional market vehicles without being much more diversified.
Although alternative investments aren’t transparent, investors can still benchmark their fund’s performance, Black says. Investors wouldn’t use a traditional benchmark like the S&P 500. Instead, look for a benchmark similar to the strategy.
“There are a wide variety of private market and alternative indices,” he says. “There are indexes tracking different hedge-fund styles, different real estate styles, different private equity styles – they all have their own benchmarks.”