Throughout my career, various investment fads have risen and fallen, and while they all have their own distinct characteristics, they all share something in common: They're packaged as "alternative investments" and often emphasize the potential for positive returns, lower risk or a combination of favorable risk-adjusted returns.
The category of alternative investments is so broad that it's almost lost any real meaning. I've seen it used to describe everything from gold and commodities, real estate, private credit and hedge funds and everything in between.
The reality is, aside from the name alternatives, the only thing assets in this category have in common is that they are not stocks or bonds.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
The Kiplinger Building Wealth program handpicks financial advisers and business owners from around the world to share retirement, estate planning and tax strategies to preserve and grow your wealth. These experts, who never pay for inclusion on the site, include professional wealth managers, fiduciary financial planners, CPAs and lawyers. Most of them have certifications including CFP®, ChFC®, IAR, AIF®, CDFA® and more, and their stellar records can be checked through the SEC or FINRA.
Alternative investments can serve an important role in a portfolio, depending on the client's situation.
Determining what goal you're trying to achieve is the most important part of incorporating alternatives into your portfolio, and the first place to start is with an education on the types of investments available.
Given the heterogeneous nature of the asset class, it is helpful to break it down into categories based on their exposure or goals.
Exploring the classes
Here are some common big "alt" asset classes:
Real assets. These are investments meant to derive their return from the real economy. Commodities, gold and real estate tend to fall into this category.
Master limited partnerships (MLPs), aka pipeline companies that ship gas throughout the U.S., can also be considered real assets.
Gold has stable value properties (it is the world's oldest currency after all), and investors tend to buy gold in times of uncertainty.
Commodities serve as an inflation hedge and include categories such as metals (precious and industrial), energy (oil and natural gas) and food (wheat, corn, coffee). Commodity prices usually rise during times of strong economic growth.
Similarly, real estate can take many forms, from private funds, direct ownership or real estate investment trusts (REITs), and have inflation-hedging attributes. Rents increase over time, and buildings tend to appreciate.
Hedge funds. The hedge fund space is extremely diverse, but typically, they're trying to take advantage of some type of market inefficiency.
A long/short equity hedge fund may short (selling) the Nasdaq, assuming it will go down, and go long (buying) a particular stock, speculating that it will outperform.
Relative value hedge funds may feel the yield spread between two bonds is too large and buy the bond with a higher yield while selling the bond with the lower yield, assuming they will move closer together.
Merger arbitrage involves betting that a merger will go through or fail and entails buying the target and shorting the acquirer (if you think the deal will pass), or vice versa if you think the deal will fail.
These are only a few examples, and you can get as exotic as insurance-linked hedge funds or tail-risk hedge funds that invest in the volatility of the stock market.
Private debt, private equity, private investments. These have been all the rage lately, with an explosion of private equity and private credit investments in the past few years.
Like with hedge funds, there are different flavors of these investments, but traditional private equity (aka PE) has an investor make a "capital commitment" to the manager.
The manager then identifies investments over time and periodically calls that capital as opportunities arise, and the manager tries to improve the value of the company.
The end goal is to sell the company either via public markets (i.e., an initial public offering, or IPO) or to some other entity.
Private debt is similar but structured around interest rates and borrowing instead of appreciating value of the underlying investment.
Long lock-ups in private investments
True private investments usually have long lock-ups, where the manager returns investment dollars over an extended period of time — 10 to 14 years in the case of equity and five to eight years in the case of debt.
Because they're gradually returning capital to investors, the funds cease to exist once all of the investments are exited.
These lock-ups are part of their "secret sauce" because they allow investors to take a long-term view on their underlying investments and attempt to find the right window to exit the company.
In recent years, more "evergreen funds" that provide limited liquidity and exist virtually forever have cropped up. This removes the need to constantly look for new investments as each fund closes.
Some funds specialize in early-stage companies (venture capital), while others purchase existing pools of private equity for investors looking to sell illiquid shares (secondary).
Banking rules that came out of the 2008-2009 financial crisis caused many traditional lenders to exit the market of riskier "middle market" companies.
This, plus the ultralow interest rate policy of the Fed post-crisis, helped fuel a boom in private credit funds as investors reached for yield wherever they could.
Looking for expert tips to grow and preserve your wealth? Sign up for Building Wealth, our free, twice-weekly newsletter.
It would behoove investors to familiarize themselves with private investments because the industry is pushing hard for them to be made available to 401(k) plans.
In fact, the current administration is expected to sign an executive order that would expand access to this vehicle in retirement accounts.
What was once the realm of high-net-worth investors seems likely to become more mainstream as time passes.
Ways to invest
In each of these classes, there are a number of ways for investors to purchase them.
High-net-worth individuals can buy private funds that invest directly through what are called private placements. This usually means giving the money directly to the managers or accessing them through an intermediary like a feeder fund.
Feeder funds are vehicles set up by third parties to pool investments for a private placement. Typically, the third party takes over the administrative responsibilities, such as tax filings, and charges an additional fee.
Going direct to the manager may require millions of dollars of commitment, but feeder funds often have much lower minimums.
Often with private equity, there's thought to be an "illiquidity premium" due to the lock-up, and because hedge funds usually report quarterly, they are thought to have lower volatility.
Going direct or through a feeder fund allows investors to reap these benefits as opposed to using more liquid options.
Net worth and income requirements
There are net worth or income requirements for most of these types of investments, and the initial investment amounts in either case may be quite steep.
You don't need to be a multimillionaire to access alts, however, as there are often publicly traded options for each. There are many mutual funds and a growing number of exchange-traded funds (ETFs) that emulate hedge fund strategies.
The mutual funds follow the 130/30 rule, meaning they can short up to only 30% and have a gross exposure to 130% of their value, so they can't act as true hedge funds.
Publicly traded options for private equity exposure are more limited, but business development companies (BDCs) are publicly traded investments that buy small, distressed companies, similar to private equity (among many other strategies).
The idea is that they're using their funds to acquire and increase the value of smaller companies the same way a private equity fund would. It's a very diverse space, and not all of them follow this strategy, so you should do significant research before investing.
Fast-tracking an IPO
There are also special purpose acquisition companies (SPACs), which are essentially public pools of money that look to buy private companies and take them public. They do an IPO to raise funds and attempt to buy a private company within a set period of time.
If they aren't successful, they have to return the money to their investors. It's a way of fast-tracking an IPO for a private company.
SPACs and BDCs have proved to be very volatile and don't necessarily share many of the attributes of their bigger cousins despite their similar goals. Care should be taken before investing in them.
There are dozens of ways to invest in real estate via ETFs, mutual funds and REITs.
Similarly, commodities can be accessed with funds and ETFs. Most people don't want to take possession of a barrel of oil, so commodity investment is done through futures. That introduces the potential for losses as contracts expire and tax complications.
Complex taxes are a hallmark of alternatives, and care should be taken to understand the impact on taxes before investing.
Are alts right for you?
As with all things investing, it depends on your situation. For individuals who take a long-term outlook and have an appropriate net worth, private placements can provide a good source of diversified return.
Commodities and real estate can help protect you against inflation, and hedge funds provide access to investments the average person may not generally have.
The benefits need to be weighed against the downside. The more complex the investment, typically the higher the costs.
Also, as mentioned above, taxes can get very complicated very quickly with alternatives, and liquidity can be limited.
Due to their nature, some investments may be very volatile or, in times of crisis, do not provide the benefits you'd hope for.
When considering the purchase of any investment, please keep in mind the following fundamental rule: If you do not understand the product's risks and how it is expected to perform in various market scenarios, do not buy it. Overall, investing involves risk, including loss of principal invested. Historical economic and performance data is not indicative or a guarantee of future results.
Certain products and your state of residence may also have their own minimum qualification requirements or certain unique limitations. These are listed in the offering material or prospectus and supplements. Please note any limitations listed within the prospectus and supplements, if more restrictive than the policies set by Equitable Advisors, will supersede our policies. Certain alternative investment products offered and sold in private placements may be appropriate only for, or available only to, accredited investors who are generally expected to be sophisticated and experienced and have the ability to understand how the product works and accept higher levels of risk.
Before purchasing an alternative investment, you should carefully consider how the strategy fits into your portfolio -- does the objective match your needs? You should consider only those alternative investments with objectives matching your own. Alternative investments can significantly expose you to nontraditional risks, such as leveraging risks, political risks, speculative risks, currency risks, forward and futures contract risks, etc., resulting in significant volatility and the possible loss of your investment. Furthermore, certain alternative investment products may be affected by regulatory or legislative changes that may affect the structure of the product or its investments. We recommend that you carefully review and appreciate an alternative investment's unique risks before investing. Regarding real estate investment trusts (REITs) in particular, there are significant risks, including, but not limited to, the possibility of losing your entire investment; no guarantees regarding future performance; upon sale or distribution of assets you may receive less than your initial investment; fluctuation of value of assets; lack of a public market; limited liquidity; limited transferability; reliance on the advisor to select and manage assets; payment of fees and various economic factors that may include changes in interest rates, laws, operating expenses, insurance costs and tenant turnover. Shares of any REIT are not suitable for all investors.
The sole purpose of this article is to provide investors with an overview of the risks, considerations and conflicts of interest associated with the alternative investment products offered by Equitable Advisors, LLC. This information is in no way intended as a solicitation, and it is subject to change. As always, you are advised to carefully read all offering memoranda, or prospectus and supplements, to help determine if any particular alternative investment program may be right for you.
Bradley Thompson offers securities through Equitable Advisors, LLC (NY, NY 212-314-4600), member FINRA, SIPC (Equitable Financial Advisors in MI & TN), offers investment advisory products and services through Equitable Advisors, LLC, an SEC-registered investment advisor, and offers annuity and insurance products through Equitable Network, LLC (Equitable Network Insurance Agency of California, LLC; Equitable Network Insurance Agency of Utah, LLC; Equitable Network of Puerto Rico, Inc.). New Canaan Group, LLC is not a registered investment advisors and is not owned or operated by Equitable Advisors or Equitable Network. AGE-8078194.1(07/25)(exp.07/29)
Related Content
- A Wealth Adviser's Seven Savvy Tips on Alternative Investments
- How to Get into Alternative Investing
- Alternative Investments Under Trump: What You Need to Know
- How to Access Private Markets with Interval Funds
- Preparing for the Worst: Retirement During a Recession
-
Don’t Miss Apple and Walmart Back-to-School Tax-Free Holiday Savings this SummerSales Tax Select states host sales tax holidays during the summer. Here’s what you can purchase.
-
The Rule of Retirement InversionThe rule of retirement inversion says that to have a great retirement, you must ask yourself what would ruin a great retirement — and then plan to avoid it.
-
The Rule of Retirement Inversion
The rule of retirement inversion says that to have a great retirement, you must ask yourself what would ruin a great retirement — and then plan to avoid it.
-
The Five Best Side Hustles for RetireesMore older people are working in retirement to boost income and stave off boredom. These gigs and hustles make the most sense for the golden years crowd.
-
Sibling Bonds May Wax and Wane: Here's How To Safeguard ThemSibling Bonds May Wax and Wane: Here's How To Safeguard Them
-
How Divorced Retirees Can Maximize Their Social Security Benefits: A Case StudySusan discovered several years after she filed for Social Security that she is eligible to receive benefits based on her ex-spouse's earnings record. This case study explains how her new benefits are calculated and what her steps are to claim some of the money she missed.
-
From Piggy Banks to Portfolios: A Financial Planner's Guide to Talking to Your Kids About Money at Every AgeFrom toddlers to young adults, all kids can benefit from open conversations with their parents about spending and saving. Here's what to talk about — and when.
-
I'm an Investment Pro: Here's How Alternatives Could Inject Stability and Growth Into Your PortfolioAlternative investments can often avoid the impact of volatility, counterbalancing the ups and downs of stocks and bonds during times of market stress.
-
Retirement in the Age of Cyber Scams: How To Protect Your Next ChapterRetirement is meant to be a time of relaxation and living life on your terms. But for many retirees, this dream is under threat from a growing epidemic — cyber scams.
-
Dow Bleeds Red Due to Big Blue: Stock Market TodaySix of the official GICS sectors were in the green, led by communications services, technology and energy stocks.
