Alternative Investment: Characteristics, Types, Investors, Pros, and Cons

What’s it: Alternative investment is an asset or instrument available as another possibility for us to generate returns and accumulate wealth. They do not fall into conventional investment categories such as equity, fixed income, and cash and cash equivalents. Commodities are an example. Other examples are hedge funds, private equity funds, and real estate. They can be our channel to accumulate more wealth in the future.

Alternative investments allow us to diversify our portfolio while generating high returns. However, they are not without risk. Compared to traditional asset classes, they are not easily sold or converted into cash. In addition, some investments are only available to accredited investors.

Why is alternative investment important to us?

Several reasons explain why alternative investments are important to us. First, it satisfies our need to diversify the portfolio. They become assets in the portfolio to generate returns and compensate for risk exposure when we invest in stocks or bonds.

Second, they are usually poorly or not correlated with major markets or traditional asset classes such as the stock market and bond market. Thus, when our returns on stocks and bonds fall, we can generate returns from alternative sources. For example, the Bloomberg Commodity Index has a low correlation with the S&P 500 Index and the Barclays Global Aggregate Index (a tracker for global bonds).

Third, alternative investments yield strong returns. For example, a private equity fund could generate annual returns of up to 54% in 2011, 12% higher than the public stock market. Likewise, coal made 160.61% returns during the commodity boom in 2021, while oil and gas made 55.01% and 46.91% in returns, respectively.

Who holds alternative investments?

Not all financial market investors participate in alternative investments. For example, investors such as pension funds and insurers may rely more on fixed income markets because they pursue stable and predictable returns. In addition, small retail investors may also not enter into alternative investments due to high costs and non-compliance.

In contrast, investors in alternative asset classes are typically high-net-worth individuals. For example, individuals with a net worth of over $1 million allocate 14% of their money to alternative investments, according to Capgemini’s 2022 World Wealth Report. This percentage increased compared to 9% in 2018.

What are the characteristics of alternative investments?

Several possibilities characterize alternative investments. First, they correlate poorly with traditional asset classes such as stocks and bonds. Second, alternative investments may be illiquid for reasons such as the lack of a secondary trading market and transfer restrictions.

For example, when we invest in venture capital – an example for a private equity fund, we cannot generate returns in a month or two. Instead, we must wait long to generate the targeted returns as the investment is allocated to fund young companies with high growth potential. And they usually can only generate positive cash flow after two or three years of operation.

Third, we find it difficult to determine the current market value of assets. An illiquid market is one reason. Fourth, alternative investments involve high transaction costs for both buying and selling.

Even though it continues to grow, the assets allocated to alternative investments are still relatively small, especially when we compare it with the total assets allocated to all investors. And characteristics above are not suitable for all investors.

What are the four main types of alternative investment?

Alternative investments include four non-traditional classes such as:

1. Commodity
2. Real estate
3. Hedge funds
4. Private equity fund

Apart from these four, collectibles – such as coins dan stamps – are sometimes also considered alternative investments. This is because we expect them to increase in value over time.

Commodity

Commodities are the main type of alternative investment. There are several ways for us to gain exposure to commodity markets. The most direct way is to invest in physical commodity products. For example, we buy gold bullion and expect the price to rise in the future. Hence, we can sell it at a profit.

Another way is to invest in commodity companies such as gold miners and oil producers. Or we can also gain exposure to commodities through commodity futures contracts, which allow us to gain price advantages without physically holding the commodity.

Apart from that, we can also buy commodity-based ETFs, which track a specific commodity index. SPDR Gold Trust GLD is an example, which has total assets under management of $51.06 billion.

Real estate

Real estate is a second alternative to investing in non-traditional asset classes. Again, we may invest directly or indirectly.

For example, we invest directly by buying office space. These investments allow us to receive regular cash inflows from rental payments. In addition, we also have the potential to gain capital appreciation when our property price increases. However, this investment may not be an alternative for some investors because it is expensive.

We can also invest directly by providing loans to other parties to buy property. As compensation, we earn interest income from them.

Meanwhile, indirect investment can be done by buying Real Estate Investment Trusts (REITs) or mortgage-backed securities (MBS). REITs own or operate real estate to generate income across various property classes such as office space, retail space, industrial estate, apartments, and warehousing. Meanwhile, mortgage-backed securities (MBS) securitize mortgage claims into fixed-income securities.

REITs and MBS allow us to earn returns without buying real estate outright. Meanwhile, REITs generate revenue from managed commercial properties. MBS generates income from mortgage bills paid.

Hedge funds

Hedge funds are pooled investment vehicles managed by professional investment managers. They raise funds and manage multiple portfolios, either securities or derivatives, with various strategies.

As the name suggests, hedge funds will take any strategy to maximize returns and eliminate risk. Their goal is to achieve high positive returns, even when the market in which to invest is down. Thus, investment managers may take both long and short positions simultaneously, aided by significant leverage. Finally, they can profit regardless of the direction of the market.

Typically, institutional investors are the primary investors in hedge funds. They may be insurance companies, pension funds, and sovereign wealth funds (SWFs). How much do they invest in hedge funds? It varies depending on their risk tolerance. They may place less than 20% of their total assets. And a more conservative one might put about 10%.

How much return is generated from the hedge fund? It depends on the strategy of each hedge fund. For example, a hedge fund focused on the commodity market generates 12.09% average returns.

By assets under management, Bridgewater Associates is the largest, with total assets under management reaching $105.7 billion as of June 30, 2021, citing the Pensions & Investments survey. Then, there is the Man Group in second place with $76.8 billion in assets under management. Here are the top 20 hedge funds by asset under management:

1. Bridgewater Associates: $105,70 billion
2. Man Group: $76,80 billion
3. Renaissance Technologies: $58,00 billion
4. Millennium Management: $52,31 billion
5. TCI Fund Management: $40,00 billion
6. D.E. Shaw Group: $39,74 billion
7. Two Sigma Investments/Advisers: $39,55 billion
8. Farallon Capital Management: $38,10 billion
9. Citadel: $37,63 billion
10. Davidson Kempner Capital Management: $37,35 billion
11. Marshall Wace: $33,11 billion
12. Anchorage Capital Group: $31,08 billion
13. Baupost Group: $31,00 billion
14. AQR Capital Management: $26,10 billion
15. Capula Investment Management: $23,90 billion
16. BlackRock: $23,09 billion
17. Wellington Management: $22,60 billion
18. D1 Capital Partners: $22,00 billion
19. Point72 Asset Management: $21,80 billion
20. GoldenTree Asset Management: $19,73 billion

Private equity funds

Private equity funds are similar to hedge funds. The two become a pooled investment vehicle. And they collect and manage funds from investors.

But, unlike hedge funds, private equity funds invest in companies. Their target is new companies with high growth potential. In addition, they may also invest in public companies and then make them private.

The two types of private equity funds are:

• Leveraged buyout funds (LBOs)
• Venture capital

LBOs rely on loans to finance company acquisitions. Their targets are established and profitable companies. The target company has a prospective market with a solid customer base and an established track record. The target is usually a public company.

After the acquisition, the target public company becomes a private company. LBOs then use the money earned by the acquired company to repay debt and achieve targeted returns.

Citing from Investopedia, well-known examples of LBOs are:

1. Energy Future Holdings: $48 billion
2. RJR Nabisco, Inc: $31 billion
3. Harrah’s Entertainment: $31 billion
4. First Data Corporation: $29 billion
5. Clear Channel: $27 billion
6. Hilton Hotel: $26 billion
7. Georgia-Pacific LLC: $21 billion
8. Freescale Semiconductor, Inc.: $18 billion
9. PetSmart, Inc.: $9 billion

Meanwhile, venture capital focuses on new or young companies such as start-ups. Their track record is still not well established but has strong growth potential. Venture capitalists then finance them to grow the business.

Once start-ups have stronger operations and are deemed to have achieved their targeted returns, venture capitalists will sell them to exchange as an exit strategy through an initial public offering (IPO). Or they sell to other venture capitalists. Here are the biggest venture capitalists in the world, citing from FundComb:

1. General Atlantic: $31 billion
2. Hillhouse Capital Group: $30 billion
3. Insight Venture Partners: $18 billion
4. Iconiq Capital: $14.5 billion
5. New Enterprise Associates: $10 billion
6. Tiger Global Management: $10 billion
7. Transition Level Investment$: $10 billion
8. Norwest Venture Partners: $7.5 billion
9. Andreessen Horowitz: $7 billion
10. Institutional Venture Partners: $7 billion