On alternative investments
Money doesn't need time off. Don't give it any. - Livermore
When most people think of investing, they generally think of traditional investments equities, bonds, precious metals and commercial paper cash. Whether it’s the index fund in a 401(k) or Roth IRA or the money in a savings account, these traditional investments are common for most individual investors. These vehicles have served many very well over the last 75 years. Interest rates were high enough to where it made sense to have cash in a savings account and to own bonds. Unfortunately, this is no longer the case. One has to search for ever more risky asset classes to obtain yields above inflation, which at the time of this writing is nearly 20%. Ah, debasement. So, where does one turn to achieve a yield that either matches or outpaces inflation? Alts, not just in crypto speak, but in the broad market as well.
There is an all encompassing category of investing beyond traditional investments, called alternative investments. One of the most dynamic asset classes, alts for short, cover a wide range of investments with unique characteristics. Many alts are becoming increasingly accessible to individual, investors, which makes knowing about them increasingly important for all types of investors.
These types of investments can vary wildly in their accessibility and structure, but they share a few key characteristics:
They are unregulated by the US Securities and Exchange Commission (SEC)
They are illiquid, meaning they can’t be easily sold or otherwise converted to cash
They have a low correlation to standard asset classes, meaning they don’t necessarily move in the same direction as other assets when market conditions change
While alternative investments share these key traits, they are also a diverse asset class. Below are eight types of alternative investments that are available to those that are willing to take on some risk to achieve yield.
1. Crypto Assets & Decentralized Finance
Crypto is a broad category that refers to capital investment made into the crypto asset space, which encompasses cryptocurrencies, decentralized finance, and equity stakes in private companies. There are several subsets of crypto, including:
Cryptocurrencies, these are the tokens that are freely traded in markets across the globe
Decentralized finance, which allows token holders to use their tokens for collateral to borrow and lend
Equity, when a startup company is offering a piece of their company in return for capital invested
An important part of crypto is the relationship between the investor and the subset of crypto in which the investor is allocating capital. Each subset functions differently and has its own tradeoffs. Currencies are the most liquid and the most volatile, decentralized finance is less liquid because ones assets are locked up to receive yield, and purchasing equity in a company is very illiquid and may take years to pay out.
2. Private Equity
Private equity is a broad category that refers to capital investment made into private companies, or those not listed on a public exchange, such as the New York Stock Exchange. There are several subsets of private equity, including:
Venture capital, which focuses on startup and early-stage ventures
Growth capital, which helps more mature companies expand or restructure
Buyouts, when a company or one of its divisions is purchased outright
An important part of private equity is the relationship between the investing firm and the company receiving capital. Private equity companies often provide more than capital to the firms they invest in; they also provide benefits like industry expertise, talent sourcing assistance, and mentorship to founders.
3. Private Debt
Private debt refers to investments that are not financed by banks (i.e., a bank loan) or traded on an open market. The “private” part of the term is important—it refers to the investment instrument itself, rather than the borrower of the debt, as both public and private companies can borrow via private debt.
Private debt is leveraged when companies need additional capital to grow their businesses. The companies that issue the capital are called private debt funds, and they typically make money in two ways: through interest payments and the repayment of the initial loan.
4. Hedge Funds
Hedge funds are investment funds that trade relatively liquid assets and employ various investing strategies with the goal of earning a high return on their investment. Hedge fund managers can specialize in a variety of skills to execute their strategies, such as long-short equity, market neutral, volatility arbitrage, and quantitative strategies.
Hedge funds are exclusive, available only to institutional investors, such as endowments, pension funds, and mutual funds, and high-net-worth individuals.
5. Real Estate
There are many types of real assets. For example, land, timberland, and farmland are all real assets, as is intellectual property like artwork. But real estate is the most common type and the world’s asset class.
In addition to its size, real estate is an interesting category because it has characteristics similar to bonds—because property owners receive current cash flow from tenants paying rent—and equity, because the goal is to increase the long-term value of the asset, which is called capital appreciation.
Like with other real assets, valuation is a challenge in real estate investing. Real estate valuation methods include income capitalization, discounted cash flow, and sales comparable, with each having both benefits and shortcomings. To become a successful real estate investor, it’s crucial to develop strong valuation skills and understand when and how to use various methods.
6. Commodities
Commodities are also real assets and mostly natural resources, such as agricultural products, oil, natural gas, and precious and industrial metals. Commodities are considered a hedge against inflation, as they're not sensitive to public equity markets. Additionally, the value of commodities rises and falls with supply and demand—higher demand for commodities results in higher prices and, therefore, investor profit.
Commodities are hardly new to the investing scene and have been traded for thousands of years. Amsterdam, Netherlands, and Osaka, Japan may lay claim to the title of the earliest formal commodities exchange, in the 16th and 17th centuries, respectively. In the mid-19th century, the Chicago Board of Trade started commodity futures trading.
7. Collectibles
Collectibles include a wide range of items, from fine wines to vintage cars to baseball cards. Investing in collectibles means purchasing and maintaining physical items with the hope the value of the assets will appreciate over time.
These investments may sound more fun and interesting than other types, but can be risky due to the high costs of acquisition, a lack of dividends or other income until they're sold, and potential destruction of the assets if not stored or cared for properly. The key skill required in collectibles investment is experience; you have to be a true expert to expect any return on your investment.
8. Structured Products
Structured products usually involve fixed income markets—those that pay investors dividend payments like government or corporate bonds—and derivatives, or securities whose value comes from an underlying asset or group of assets like stocks, bonds, or market indices. Examples of structured products include credit default swaps (CDS) and collateralized debt obligations (CDO).
Structured products can be complex and sometimes risky investment products, but offer investors a customized product mix to meet their individual needs. They're most commonly created by investment banks and offered to hedge funds, organizations, or retail investors.
Structured products are relatively new to the investing landscape, but you’ve probably heard of them due to the 2007-2008 financial crisis. Structured products like CDO and mortgage-backed securities (MBS) became popular as the housing market boomed before the crisis. When housing prices declined, those who had invested in these products suffered extreme losses.
I would rather earn 1% off of a 100 people's efforts than 100% of my own efforts. - John D Rockefeller.
In sum, the alternative asset category is diverse and exciting. It can deliver results that are unmatched in traditional markets. One must remember that there is always a trade off between risks and rewards. In order to be rewarded more one needs to take on more risk. As this may be suitable for some, it is not ideal for many, thus one should approach this category with caution. The old adage of only allocating an amount of capital one is willing to lose is a wise heuristic. In most times this is not optimal to take on more risk in order to keep ones head above water, but this is the reality of the world in which we live. Whether it be crypto or real estate the returns one may receive are contingent on myriad factors that can be affected at the micro and macro levels. Bet accordingly.