What Are Alternative Investments? Definition, Advantages and Strategies

Stocks and bonds tend to get the lion’s share of attention in the general investing community. And while these traditional investments are some of the most popular financial assets sought by individual investors or retirement savers, they are far from the only type of investments available to the at-large market.

Enter the world of “alternative investments.”

Alternative investments are popular for many reasons, whether they are being used for portfolio diversification, to find an edge or to meet goals along various time horizons.

So, what are alternative investments? Let’s take a closer look at a definition, who commonly holds such alternative assets, some examples of alternative investments and related investing strategies.

What are alternative investments?

To more easily understand what are alternative investments, it’s worth looking first at what they are not. Traditional investments can be primarily broken down into three categories:

  1. Stocks: These are shares of publicly-listed companies that can be bought and sold. While stocks may experience price volatility, they typically grow over the long term and are commonly held in retirement 401(k)s or through a retail brokerage account.
  2. Bonds: This is debt issued by companies, institutions or governments to raise funds. Because bonds pay out on a predetermined timeline and at a set interest rate, many savers depend on them for fixed income.
  3. Cash: Cash is commonly used as a short-term investment, think money market accounts. Typically, investors and consumers can take advantage of interest when placing their savings or excess funds in cash investments.

Conversely, an alternative investment is one that does not fall into any of these three buckets and which does not have a strong correlation with traditional investments. Because these investments may not be subject to the same factors and risks as stocks, bonds and cash, they can benefit portfolios by providing diversified exposure or returns.

Thanks to these advantages, alternative investments are quickly growing. Financial data firm Preqin estimated there were $10.74 trillion in global alternative assets under management (AUM) in 2020. That number is expected to grow 60% by 2025 (at a compound annual growth rate of 9.8%) to total $17.16 trillion in AUM.

Broadly speaking, there are a few other defining characteristics of alternative assets. They are:

  • More illiquid than traditional investments, meaning they cannot be easily sold or converted to cash on a daily basis (whereas investors nowadays can sell stocks with a few clicks and get account credits instantly).
  • Generally not regulated by the U.S. Securities and Exchange Commission (SEC), which is not to say they are entirely unregulated. The entities that offer alternative investments may be required to register with the SEC, however.
  • Often packaged into complex investment structures that may seem complicated for Main Street investors.

The allure of alternative investments is that they can offer higher return potential than traditional investments, along with portfolio diversification. The unique risk and investment profiles of alternative assets allow investors to make long-term bets or find an edge on the market through a nuanced investment strategy.

There is a misconception that alternative investments are too esoteric and not tied to tangible assets in the way traditional investments are. This is not true, as the profile of each alternative asset is different. For instance, real estate investing is considered an alternative investment, and is tied to a very tangible asset: real estate. (We’ll look at a couple more examples in a bit).

Who owns alternative investments?

Alternative investments are typically sought and owned by institutional and accredited investors. Institutional investors are organizations that make large-scale investments; they may be banks, public pensions, asset management firms, trusts, insurance companies, higher education endowments and various types of funds (both mutual and hedge).

Accredited investors, on the other hand, are typically high-net-worth individuals who meet certain income and asset requirements set by the SEC. 

Often, these two investing groups are the primary audience for alternative assets due to the fact such investments usually require:

  • High minimum investments.
  • Long lock-up periods during which shares cannot be redeemed or sold.
  • Familiarity with complex fund and investment structures.

However, this does not mean retail investors are entirely shut out of alternative investments. Increasingly, more financial products have been introduced to help Main Street investors take advantage of the portfolio diversification benefits of alternative investments, while still enjoying a measure of liquidity. An example of this is exchange-traded funds (ETFs). These liquid alts — called so because they are more liquid than other alternative investments — follow specific investing strategies (like index-tracking or factor investing) and can be used by individual investors to gain diversified exposure, investing edge and daily liquidity. ETFs also eliminate many barriers to investing, like income requirements, minimum investments and lock-up periods.

6 types of alternative investments

Now that we’ve answered the question of “What are alternative investments?”, let’s take a look at some of the most well-known examples of such alt assets.

1 Hedge funds

Hedge funds are pooled investments, often having raised funds via multiple institutional or accredited investors. The difference between a mutual fund and a hedge fund is that 401(k) investors don’t have access to hedge funds, which are offered privately. 

A hedge fund may hold a variety of assets, both liquid and illiquid. Whereas a mutual fund may invest heavily in stocks and bonds, a hedge fund — in addition to holding equities and fixed-income products — may invest in derivatives (e.g., options, futures, swaps), real estate, cryptocurrencies or sovereign debt.

Hedge funds very often have minimum investment and lock-up requirements that are typical of alternative investments. Also, they follow specific, nontraditional investing strategies, such as short selling, investing in emerging markets or pairs trading.

2 Private equity and venture capital

Companies listed on major stock exchanges aren’t the only ones that can grant shares to investors. Private companies commonly issue equity shares to investors in exchange for capital, as well as other resources.

Private equity firms, for example, employ various experts who can offer portfolio companies help with strategy, scaling up, taking products to market or leadership decision-making. 

There are multiple forms of private equity, including:

  • Venture capital, investing in startups or supplying seed money for early-stage ventures.
  • Buyout capital, extending investment to distressed firms in exchange for operational control or board seats.
  • Growth capital, accelerating business growth with focused investment.

Private equity ownership stakes are often a long-term investment, as it takes time for companies to grow or for the results of a restructuring to become known. Ultimately, the goal is often to sell the stake for a profit, or to benefit through an initial public offering (IPO) of a portfolio company.

3 Real estate

Real estate is a multifaceted asset class, encompassing private investment properties and real estate investment trusts (REITs), for example, and is not closely correlated with traditional investments. Such characteristics make real estate investing a common alt strategy. 

4 Collectible tangible assets (e.g., art and antiquities)

Art lovers aren’t the only ones who will bid millions for a masterpiece. Fine art and other collectibles, including antiquities, classic cars and vintage wines, are often used as alternative investment vehicles. Increasingly, such tangible assets are being leveraged to stash wealth, as well as generate profit in the long term: like if a particular artist sees greater demand for their works, pushing auction prices up.

There are, however, substantial risks to collectible tangible assets. For example, there’s no guarantee the asset will appreciate. That risk, combined with high acquisition costs and the lack of liquidity make such investments suitable for a select audience. Also, storage costs and insurance policies are added considerations for such alternative assets.

5 Private debt

Large-scale and institutional financing needs can often fall outside the realm of what a traditional bank loan can do. When in need of such financing, borrowers may turn to private debt markets.

Private debt — sometimes also called alternative credit — refers to financing that is offered on nonstandard or customized terms negotiated between the borrower and private lender. Such forms of financing may not be readily accessible through traditional credit markets and sources.

Categories of private debt may include direct lending, mezzanine, distressed debt and specialty financing. Regardless, as an alternative investment, private debt can help investors add either portfolio performance or diversification.

6 Commodities

Another alternative investment tied to physical assets, commodities are often sought out for their lack of correlation with traditional investments. Commodities typically experience cycles independent of larger market factors, which makes them useful for portfolio diversification, or as a hedge on traditional investments. For instance, when stocks and bonds fall, many investors may turn to a safe-haven asset like gold, which may carry opposite momentum.

Commodities include precious metals, agricultural products and energy resources. Such assets are often traded with derivatives like futures contracts, which further provides investors with ways to hedge against market turmoil or price volatility.

Magma as an alternative investment

Hedge funds are a popular alternative investment, and at Magma Capital Funds we approach investing with a sophisticated strategy that combines an algorithmic approach with machine learning tools.

Want to learn more about fund specifics or how you can invest? Contact us today.

This article is for informational and educational purposes only and is not an offer to sell or a solicitation of an offer to buy any securities or other instruments through Magma or by any other means. The information contained herein is not intended to provide, and should not be relied upon for investment, accounting, legal or tax advice. This blog post does not purport to advise you personally concerning the nature, potential, value or suitability of any particular sector, geographic region, security, portfolio of securities, transaction, investment strategy or other matter. No consideration has been given to the specific investment needs or risk-tolerances of any recipient as part of this publication. The recipient is reminded that an investment in any security is subject to a number of risks including the risk of a total loss of capital, and that discussion herein does not contain a list or description of such relevant risk factors. Please be advised that past performance is no guarantee of future results. The recipient hereof should make an independent investigation of the information described herein, including consulting its own tax, legal, accounting and other advisors about the matters discussed herein. This report does not constitute any form of invitation or inducement by Magma to engage in investment activity or to invest in any Magma product offerings.