What once guided investors successfully may not pave the way forward. The daunting challenges in public and private markets persist, creating a need for alternative sources of income that require effort upfront but can provide long-term financial benefits with minimal ongoing work. Through a dynamic approach to asset allocation, that is, one that accommodates new industries, securities, and other economic changes, a portfolio can reduce overall risk without compromising long-term growth prospects. Since alternatives exhibit traits that set them apart from stocks and bonds, adding them to a portfolio can lower volatility, provide broader diversification, and enhance returns.
Cryptocurrency isn’t directly tied to equity and debt markets, and this is often seen as a benefit as traditional markets face a crisis. Although the fundamental principles of supply and demand apply, the factors influencing changes in price are distinct. Bitcoin, the most prominent cryptocurrency, exerts a strong influence on the overall digital asset market due to its widespread adoption. While its volatility has produced unstable short-term pricing patterns, it has been the best-performing investment of the last decade. Before integrating blockchain-based assets into your portfolio, you must thoroughly research online venues and regulatory requirements to understand how to crypto in a safe and compliant manner.
This article will delve into what constitutes alternative investments, why they are drawing increasing attention, and how to integrate them into a well-rounded investment strategy.
Alternative Investments Explained: Definitions And Real-World Examples
Alternative investments fall outside of the standard asset classes commonly accessed by investors, such as public equities, fixed income, or cash. Although no universally agreed-upon list exists, certain investments are widely accepted as alternatives due to their potential to offer diversification, notably hedge funds, real assets (property, infrastructure, commodities, natural resources, etc.), and structured products. Alternatives are typically less liquid, meaning they can be harder to buy and sell, and require a longer investment period before any value is realized. The markets are less competitive, with fewer investors, and the inability to take both long and short positions may pose some challenges.
Nearly all alternative investments present the following features that single them out:
- Low correlation with traditional investments: Alternatives often exhibit lower correlations with well-established financial instruments, which means they can move independently, smoothing out market lows and highs over time.
- Core worth that’s not easy to evaluate: For intellectual property, for instance, there may be no reliable measure of investment value at any point in time. Without a broad peer universe or public indices, it’s difficult, if not impossible, to determine if a valuation is in line with market norms.
- Relatively low liquidity: Alternatives trade infrequently or with low volume, so returns are hard to observe and can be affected by the decisions of just a few investors. The low liquidity can be explained by the absence of centralized markets.
The Rationale For Allocating To Alternative Investments
Investors lean on alternatives for several reasons, including portfolio diversification. Hedge funds, private capital, and real assets can potentially generate higher returns than traditional investments, but they have minimum investment requirements that range from hundreds to thousands of millions of dollars. Once reserved for institutional investors and high-net-worth individuals. Alternative investments have become available to regular investors owing to interval funds, BDCs (business development companies), REITs (real estate investment trusts), and registered funds of funds. Diversification can enhance risk-adjusted returns by combining assets with different risk levels.
Allocations to alternative investments can offer high returns, but as with any financial decision, it’s critical to first understand what you’re trying to achieve and then identify the best way to get there. During periods of market downturns, alternatives have proven more resilient, maintaining their value or even appreciating, thereby providing portfolio diversification. As opposed to traditional investments (e.g., securities) that can be sold instantly, alternative investments (e.g., real estate) prevent panic selling or forced liquidation at unfavorable prices. Of course, not all alternatives perform well, so diversification within alternatives is just as important as diversifying away from traditional assets.
Returns from many alternative investments are taxed as current income at the highest marginal tax rate, but there are strategies that allow investors to defer taxes on gains. By way of illustration, you can keep more of your money invested and working for you by reinvesting the proceeds from the sale of an investment property into a like-kind property within six months.
Equally, you can donate appreciating assets to qualified charities, which results in a fair market deduction while avoiding taxes. Investing requires substantial due diligence measures to more accurately assess suitability.
When Evaluating Alternative Investments, Several Critical Factors Deserve Attention
The rate of return of alternative investments isn’t guaranteed, yet there is potential for it to be higher than that of traditional investments. There are a few critical considerations to bear in mind when allocating to alternatives.
- The risk and return profile: Alternatives present unique risk factors such as illiquidity, manager risk, and operational complexity. The greater the risk, the higher the potential for profit/loss. Consider your investment goals and aim for a portfolio that aligns with your individual needs.
- Liquidity requirements: Alternatives tie up capital for long periods of time. For example, private equity funds typically have 10-year commitments, whereas real estate may restrict withdrawals. Cryptocurrency often fluctuates by huge amounts within short periods, so a long-term investment approach is better suited.
- Investment minimums: Many alternatives are restricted to individuals with specific income levels or net worth thresholds. Determine if you can meet the eligibility criteria and can commit the required capital without compromising portfolio diversification.
- Due diligence and manager selection: Last but certainly not least, look for a portfolio manager with a proven track record in the specific asset class you’re interested in. Look for transparency in reporting, alignment of interests, and consistency in strategy execution across market cycles.
It’s time, now more than ever, to have a thoughtfully designed portfolio that allows you to embrace market opportunities while preparing for the unexpected. The alternative investments landscape is rapidly evolving, so regularly educate yourself about emerging opportunities.
