Alternative investments: Beyond stocks and bonds

Alternative investments (“alts”) refer to investable assets that don’t fit within the conventional, “traditional” categories of stocks, bonds, and cash.

Alternative investments is a generalized term that bundles together a diverse array of specialized, niche, or non-mainstream markets. Think of hedge funds, collectible coins, fine art, and even trading cards. As you might guess, not all assets within this category are financial in nature.

Plus, there are no universally standardized rules defining the alternatives category as a whole (although institutions may have their own rules defining alternative investments).

Alts sometimes involve highly specialized instruments that are unfamiliar to retail investors. They can be hard to value because of a lack of market data or absence of standard analytical models, and thus subject to minimum holding periods (“lockups”).

For these reasons, some (but not all) alts are only available to “accredited investors” whose income and/or net worth exceeds a specific threshold.

Common types of alternative investments

Although the category is diverse, certain types of alternative investments are more widely known:

• Real estate. Real estate investments typically consist of residential and commercial properties for rental income or capital appreciation.
• Commodities. Investors typically gain exposure to commodities via futures contracts, options, or exchange-traded funds (ETFs). Aside from precious metals, investors rarely purchase the physical commodity. There are five main commodity classes:
  • Energy (e.g., crude oil, natural gas, gasoline)
  • Metals (e.g.,gold, silver, copper, and rare earth metals)
  • Livestock (hogs, cattle)
  • Grains (wheat, corn, soybeans)
  • Softs (coffee, cocoa, sugar, cotton)
• Coins. Although gold and silver generally belong to the commodities category, gold and silver coins are also valued for their aesthetic design and quality, minting date, historical or commemorative significance, and rarity. Precious metals coins usually trade at a premium above the corresponding “spot” prices (for gold or silver bullion or bars).
• Hedge funds. Hedge funds are managed investment vehicles that deploy advanced trading strategies (such as going “short” the market, options trading, and so on) in an attempt to outperform a standard benchmark, such as the S&P 500. Because many hedge fund strategies are risky, access to these funds is often limited to accredited investors, institutional investors, and high-net-worth individuals.
• Private equity. Private equity refers to direct investment in private companies by funds and pools of individual investors. Private investors may also pool funds to buy out or acquire public companies.
• Private credit. Just as private equity exists outside the public stock market, private credit is lending that takes place outside the traditional banking world.
• Cryptocurrencies. Cryptocurrencies are digital currencies that rely on an encrypted digital network to execute, verify, and record transactions independent of a centralized authority, such as a government or bank. Despite the “currency” moniker, cryptocurrencies function more like speculative investments than alternative forms of money.
• Non-fungible tokens (NFTs). Non-fungible tokens are digital assets on a blockchain that have their own unique and individual identification codes. Each “minted” NFT is one of a kind and cannot be replicated or replaced. Although many digital assets can be minted as NFTs, the most popular use has been in the realm of digital art.
• Fine art. Fine art is a collectible asset that includes paintings, drawings, sculpture, installations, and other visual works.
• Collectibles. The collectibles asset category can include anything from jewelry pieces to furniture to rare trading cards, as long as they have the potential to appreciate over time.

The pros and cons of alternative investing

Like all types of investments, alternatives have their pros and cons. In general, the positives are about the benefits of diversification, while the negatives are about risks and fees.

The benefits of alternative investing include:

• Potential for higher risk-adjusted returns. Strategies like hedge funds and private equity aim for outsize gains compared to traditional investments like stocks and bonds. Their correlation with traditional assets is often low, which helps to reduce overall portfolio risk.
• Access to unique assets. Art, rare coins, and private credit offer exposure to niche markets not available through traditional assets.
• Inflation hedge. Assets like real estate and commodities have historically offered some protection against inflation by maintaining or increasing in value over time.

Alternative investing also has drawbacks:

• Illiquid and volatile. Many alts, such as private equity and collectibles, can be difficult to sell quickly or may have lockup periods. Others, such as crypto and metals, can experience significant price swings.
• Complex and nontransparent. Some alts involve sophisticated strategies and opaque pricing. These characteristics make them hard to evaluate and costly because of the fees associated with active management.
• Lightly regulated. Many alts fall outside traditional regulatory oversight, exposing investors to added legal and compliance risks.

Once you’ve added alternatives to your portfolio, it may be difficult to quantify success against an appropriate benchmark. You could compare commodity investments to commodity indexes, private equity to the S&P 500, and private credit to returns on high-yield (“junk bond”) indexes, but it may be difficult to assess the performance of an investment in fine art or collectibles.

The bottom line

Alternative assets can be an effective way to diversify an investment portfolio, but because of their specialized nature, and in some cases lack of standardization, they tend to carry risks that may exceed many investors’ capital resources, risk tolerance, or expertise.

But many of the alternative asset classes are available to today’s retail investor through ETFs, crypto platforms, or commodity exchanges. And if you have an eye for collectibles, you can get alts exposure that way.

Alternative investing is about adding pieces to your portfolio that aren’t correlated with the ebbs and flows of traditional assets, so they might perform well during a recession or a bout of inflation.