Exploring the Basics of Alternative Investments

Exploring the Basics of Alternative Investments

Alternative investments offer a range of options to invest outside conventional assets such as stocks and bonds. From private equity to hedge funds to venture capital, investors have more opportunities to take their asset allocation further and turn a profit with a low correlation to traditional investments.

Alternative Investments In a Nutshell

Alternative investments are simply assets that do not belong to traditional investment categories like cash, stocks, and bonds.

Instead, they are investments in assets such as private equity, hedge funds, and venture capital. Additionally, alternative investments can include tangible assets like precious metals, wine, and real estate.

Alternative investments could provide some boost to an investor’s portfolio, with many of them capable of offering considerable returns relative to conventional assets.

While investors have different risk tolerance and views about the market, the wide variety of alternative investments makes them an option worth considering.

People Suitable for Alternative Investments

Generally, alternative investments show a low correlation with traditional investments. Some of them also significantly lack liquidity and have very complex valuations.

Such factors have made particular alternative investments pretty popular with financially sophisticated investors such as high-net-worth individuals (HNWIs) and financial institutions officially recognized by the Securities and Exchange Commission (SEC).

That is because many alternative investments are not listed on public exchanges. In fact, they are usually deemed unregulated by the SEC.

There are a few ways you can be eligible to buy alternative investments as an accredited investor:

1st Option: Have an annual income of USD$200,000 to USD$300,000 for a couple of years or the last two years.

2nd Option: Keep your net worth at USD$1 million or higher.

3rd Option: Satisfy the SEC’s “defined measures of professional knowledge, experience, or certifications.”

Common Types of Alternative Investments

Private Equity Funds

Private equity funds are pools of funds intended for investing directly in private or public companies with the potential to generate a high rate of returns. This type of investment vehicle focuses on acquiring a majority stake or controlling interest in a firm.

In addition, private equity funds actively manage their portfolio companies, raising intellectual and financial capital. When a private equity fund buys a stake in a firm, they usually do it to reorganize the business and inject capital to speed up its growth.

The fund makes money once it liquidates its stake. This can be done by taking one of its portfolio companies public through an initial public offering (IPO) or selling it to another firm.

Hedge Funds

Hedge funds are pooled investment funds that focus on generating high returns through different, usually risky methods. From public securities to exchange-traded derivatives to currencies to startups, hedge funds can use market players’ investment dollars to bet on any assets.

Hedge funds are often created as private investment partnerships. There the general partner takes care of the portfolio’s management and investment decisions, which are limited by the fund’s mandate.

Venture Capital Funds

Venture capital funds are money provided to early-stage companies with high growth potential in exchange for equity. Similar to private equity funds, venture capital funds also actively manage their portfolio companies and provide essential expertise.

However, what separates those two is that venture capital participants typically invest for more extended periods than private equity investors.

Venture capital funds also collaborate with the portfolio company and keep an eye on the progress, conducting financing rounds when certain targets have been achieved. Venture capital funds withdraw their investments once the company goes public, enters a merger, or agrees to an acquisition.

Real Estate

Real estate is perhaps the most accessible alternative investment in the market. Many people are already making their money work through real estate by owning their homes.

Real estate investing involves buying actual property or funds that invest in this asset class, like real estate investment trusts (REITs).

Investors who opt for real estate expect higher value due to appreciation over the long term. On the other hand, rental properties such as apartment buildings or shopping centers can provide a steady return on your investment.

Investing in Alternative Investments

Owning alternative investments can be more challenging than owning conventional ones.

Alternative investments may offer higher returns and better diversification, but your risk exposure could also be greater. So if you’re looking to buy alternative investments, detailed due diligence and research will be needed.

Another thing to keep in mind is that your access to alternative investments could be limited if you’re not an accredited investor.

While that is the case, you can try alternative investment mutual funds or exchange-traded funds (ETFs), although they may be more expensive than other funds. Still, they are safer options for unaccredited investors, considering they are publicly traded and regulated by the SEC.

Some financial firms can also help you find suitable funds and ETFs. But working with a financial advisor is often a better option since they can offer professional advice that would help you get the results you want.

Factors to Consider Before Buying Alternative Investments

Fewer Regulations

Many alternative investments are unregistered and have fewer regulations from the SEC. Still, the purview of the Dodd-Frank Act covers alternative assets. Therefore providing the SEC a way to examine their operations and practices.

Less Transparency

Considering the lack of regulation from the SEC, public regulatory filings of alternative investments amount to few to none at all. Such a lack of transparency provides investors with little information to work with.

Pricey Investments

Alternative investments are not for everyone; therefore, their minimum investments and fee structures tend to be more expensive.

Lack of Liquidity

Alternative investments can be hard to buy or sell since they are not listed on public exchanges. In addition, private equity funds and hedge funds usually have lock-up periods that require investors to stay invested for a specific time during which withdrawing money is not possible nor an ideal move to make.

More Risks

While alternative investments can generate higher returns, they can also carry more risks. Moreover, many alternative assets use risky strategies such as short selling or trading derivatives.

Not Easy to Value

Determining the underlying value of alternative investments can be difficult as they are inherently complicated when it comes to this process. Plus, their valuations are not safe from subjectivity and may vary, depending on the appraiser.

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