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Alternative investments complement our portfolio, in addition to conventional investments such as stocks and bonds. However, alternative investments have pros and cons, just like traditional investments.
For example, alternative investments allow us to deliver superior performance. In addition, we can also diversify our portfolio because some alternative instruments are lowly correlated with conventional asset classes such as stocks and bonds. Thus, we can generate returns even when traditional assets are underperforming.
However, alternative investments often require significantly more initial capital than when we invest in stocks or bonds. In addition, some alternative assets are less liquid, making us unable to attract investment when we need it most.
What is an alternative investment? It refers to investments in asset classes other than conventional assets, such as stocks, time deposits, and fixed-income securities. Commodities are a typical example, where we can buy physically or through related instruments such as exchange-traded funds (ETFs). Other examples are real estate, hedge funds, and private equity funds.
What are the potential upsides of alternative investments?
Alternative investments offer several potential advantages. First, they provide an opportunity to improve our portfolio performance by adding them to a traditional portfolio. Second, they allow us to diversify and reduce volatility because they are lowly correlated with traditional assets.
Increased performance
Increased performance is a potential upside of investment alternatives. Indeed, alternative investments do not guarantee high returns. However, some outperform traditional asset classes.
For example, during the commodity boom after the Covid-19 pandemic, energy prices increased dramatically, resulting in significant profits. The coal delivered 160.61% returns in 2021. Meanwhile, oil and gas delivered 55.01% and 46.91% in returns.
Likewise, private equity funds also have the potential to generate high returns. For example, a private equity fund posted up to 54% in 2011. Those returns are 12% higher than the public stock market.
Alternative for diversification
Investors are generally attracted to alternative investments because it provides an opportunity to diversify their portfolio. Historically, returns on alternative investments have been low in correlation with traditional investments over the long term.
For example, the Bloomberg Commodity Index, which tracks global commodity prices, correlates about 0.3 with equities in the US, tracked by the S&P 500 Index. In addition, the commodity index is also correlated by about 0.3 with global bonds, tracked by the Barclays Global Aggregate Index.
Volatility reduction
The low correlation allows us to mix a less volatile portfolio. In addition, we can improve our risk and return profile by adding alternative investments to our traditional investment portfolio.
Thus, we can potentially generate returns – at a tolerable risk level – when our traditional investments are down. As a result, our portfolio does not drop significantly when traditional assets fall.
What are the potential downsides of alternative investments?
The potential downside of alternative investments is an illiquid market. Thus, it is difficult for us to decide on pricing. In fact, we may find it challenging to track historical performance to choose before investing.
Another potential downside is the high minimum cost and investment. In addition, alternative investments are generally unregulated, unlike stocks and bonds.
Hard to find the ideal portfolio
As with traditional assets, alternative investments vary widely. Thus, there are challenges to forming an ideal portfolio, including in:
- Selecting their type, e.g., commodities, real estate, or hedge funds?
- Choosing a portfolio manager when we are not actively managing
- Determining how many dollars we allocate
- Measuring risk and return reliably
This challenge increases because some alternative investments are illiquid. Or they do not have an open market, such as the stock exchange. Thus, it is challenging to obtain related data, for example, to measure their historical returns and risks.
High returns come with high risk
As the saying goes in investing: high returns come with high risk. So, indeed, we can improve portfolio performance by getting high returns through alternative investments. But, we must also realize they have a high risk.
High returns on alternative investments may come from something other than increased prices. For instance, it may stem from our ability to exploit tax advantages as we invest in real estate. In addition, exploiting mispricings is crucial because alternative investments are illiquid, making it difficult to determine their fair prices.
Then, alternative investments such as hedge funds may also use significant leverage to earn high returns. Or, they use it, combined with long or short positions, to profit even when the market moves in the opposite direction.
Illiquid
Indeed, few alternative investments are publicly listed. ETFs and REITs are examples. Thus, they are relatively liquid.
However, alternative investments such as private equity funds and real estate are generally less liquid. In addition, they are usually private, not public. Thus, we may find it difficult to withdraw our investments or sell them at any time because they are bound for a long period.
Less regulated
Unlike stocks or bonds, alternative investments are generally unregulated. Therefore, they are usually not subject to reporting requirements.
However, after the 2008 crisis, there has been increasing attention to alternative investments. As a result, policymakers increase oversight to reduce systemic risk. Understandably, the funds circulating in alternative investments are substantial, so they can significantly impact financial markets.
Low price transparency
Alternative investments generally do not have a public market like stocks and bonds. Thus, there is little available price information.
For example, we will find it more difficult to find commercial real estate prices than stock prices. We may have to visit or contact a real estate agent to find their price list. On the other hand, we can easily find stock prices; even on smartphones, we can see them.
As a result, there are challenges in pricing. In addition, we may also find it difficult to track historical performance to determine return and risk before deciding to invest.
High cost
Alternative investments tend to have high costs. And they will vary significantly between their types. For example, a hedge fund might charge a fee of 2% of the total invested fund. It may also retain a certain percentage of excess returns (profits above an agreed benchmark).
Meanwhile, we may have to cover 2% of our committed capital to pay management fees when investing in equity funds. Although relatively inexpensive, ETFs also have several costs, including operating and trading costs.
High minimum initial investment
Many alternative investments require a significant minimum initial investment. For example, a private equity fund may require $25 million as a minimum investment, even if some are lower than that amount. In addition, they also need us to hold the investment for at least 10 years.
Meanwhile, hedge funds usually require a minimum investment of $100,000 to more than $2 million. Likewise, the minimum investment in real estate is also significant unless we buy ETFs if we want the cheapest and easiest.
