Module 2- Investment Alternatives: What Are Alternative
Investments?
What Is an Alternative Investment?
Alternative investments comprise financial assets besides stocks, bonds, mutual
funds, and exchange-traded funds.
An alternative investment is a financial asset that doesn't fall into one of the
conventional investment categories. Conventional categories include stocks,
bonds, and cash.
Alternative investments can include private equity or venture capital, hedge funds,
managed futures, art and antiques, commodities, and derivatives contracts.
Real estate is also often classified as an alternative investment.
KEY TAKEAWAYS
● An alternative investment is a financial asset that does not fit into the
conventional equity/income/cash categories.
● Private equity or venture capital, hedge funds, real property, commodities, and
other tangible assets are all examples of alternative investments.
● Most alternative investments have fewer regulations from the U.S. Securities and
Exchange Commission (SEC) and tend to be somewhat illiquid.
● While traditionally aimed at institutional or accredited investors, alternative
investments have become feasible for retail investors via alternative funds.
● Common forms of alternative investments include real estate, commodities,
cryptocurrency, and collectibles.
Understanding Alternative Investments
Most alternative investment assets are held by institutional investors or accredited,
high-net-worth individuals because of their complex nature, lack of regulation, and risk.
Many alternative investments have high minimum investments and fee structures,
especially when compared with mutual and exchange-traded funds (ETFs).
These investments also have fewer opportunities to publish verifiable performance data
and advertise to potential investors. Although alternative assets may have high initial
minimums and upfront investment fees, transaction costs are typically lower than those
of conventional assets because of lower levels of turnover.
Most alternative assets are fairly illiquid, especially compared with their conventional
counterparts. For example, investors are likely to find it considerably more challenging
to sell an 80-year-old bottle of wine than 1,000 shares of Apple Inc. (AAPL) because of
the limited number of buyers.
Investors may have difficulty valuing alternative investments since the assets and
transactions involving them are often rare. For example, a seller of a 1933
Saint-Gaudens Double Eagle $20 gold coin may have difficulty determining its value, as
only 11 are known to exist, and only one can be legally owned.12
Types of Alternative Investments
Real Estate - as a financial product includes investing in physical properties or
property-based securities, real estate crowdfunding platforms, real estate investment
trusts (REITs), and real estate mutual funds. In addition to capital appreciation of
tangible assets, investors strive for operating income to potentially provide ongoing,
stable cash flow.
Commodities - are raw materials such as gold, silver, oil, or agricultural products.
Investors can invest in these tangible goods that have real-world uses and often
perpetual demand due to the underlying characteristics of what they are.
Farmland - a blend of real estate and commodities, investors can turn to farmland as an
alternative investment. In addition to the benefits of physical land, farm owners may also
receive ongoing cash proceeds should operations and sales of commodities yield
positive results.
Art and Collectibles - some investments may double as a hobby, with art, sports
memorabilia, entertainment memorabilia, high-end watches, or other collectibles acting
as alternative investments. These items may have historical worth or develop worth
over time as related parties (i.e., the artist, the associated movie star, or the associated
athlete) become more historic.
Cryptocurrencies - the emerging form of digital currency, cryptocurrency is seen as an
alternative investment as it is outside the traditional scope of stocks and bonds. Though
some may claim cryptocurrency does not offer a strong hedge against other risk-on
investments, it may provide capital appreciation or passive income due to staking
rewards.
Venture Capital/Private Equity - blurring the lines of an alternative investment, venture
capital, or private equity is simply a refined branch of stock investments. Instead of
trading shares of public companies in an open market, investors may seek alternative
avenues to put capital into private companies or start-ups.
Peer-to-Peer Lending - investing in peer-to-peer lending translates to making loans to
individuals or businesses through online platforms that connect borrowers with
investors. Peer-to-peer lending takes a very similar form to investing in bonds, though it
is done on more private markets and often entails transacting with riskier clients, and
thus is a risky investment.
Alternative Investments Accessible to Retail Investors
Table with 3 columns and 23 rows.
Category Access Method Key Features/Notes
Buying physical property
(rental, commercial). High
Direct Property
Real Estate capital needed, illiquid,
Ownership
requires active management
or costs.
Publicly Traded Real High liquidity; available
Estate Investment through standard brokerage
Trusts (REITs) accounts.
Accessible via standard
REIT Mutual Funds &
brokerages; offers
Commodities Exchange-Traded
diversification within real
Funds (ETFs)
estate sectors.
Tracks indexes (gold, silver,
Commodity ETFs oil, agriculture, etc.);
standard brokerage access.
Purchase via dealers (coins,
Physical Gold & bars); requires
Precious Metals storage/insurance
considerations.
Exposure to commodity
Futures-Based
futures contracts; accessible
Commodity Funds
via standard brokerages.
Mining Company Indirect exposure via publicly
Cryptocurrency
Stocks traded mining companies.
Purchase via crypto
Direct Cryptocurrency
exchanges (e.g., Coinbase,
Holdings
Gemini); requires digital
Table with 3 columns and 23 rows.
Category Access Method Key Features/Notes
wallet/custody
understanding.
Tracks crypto prices (incl.
Crypto ETFs spot Bitcoin ETFs); standard
exchange access.
Invests in companies
Hedge Fund-Like Blockchain-Focused
involved in blockchain/crypto
Strategies Equity ETFs
technology.
Funds using hedge fund
Liquid Alt Mutual strategies (long/short,
Funds and ETFs managed futures, etc.); daily
liquidity.
Designed to mimic hedge
Hedge Fund
Private Equity & VC fund index returns using
Replication ETFs
liquid securities.
Publicly traded; invests in
Business Development debt/equity of
Cos (BDCs) small/mid-sized private
businesses.
Buy shares in late-stage
Pre-IPO Investing
Private Credit private companies before
Platforms
IPO; illiquid, high minimums.
Exposure to private lending
BDC Funds via publicly traded funds
holding BDC assets.
Registered funds investing in
private credit; offer periodic
Interval Funds
(e.g., quarterly) share
repurchases; less liquid.
Direct lending to
individuals/businesses via
Peer-to-Peer (P2P)
platforms (e.g., Prosper,
Lending
LendingClub); involves credit
risk.
Table with 3 columns and 23 rows.
Category Access Method Key Features/Notes
Specific interval funds
Private Credit Interval
Infrastructure focused on private credit
Funds
assets.
Invests in publicly traded
Infrastructure
infrastructure companies
ETFs/Mutual Funds
(utilities, energy, transport).
Publicly traded companies
owning operating
Yieldcos
infrastructure assets
generating stable cash flows.
Specialty REITs focused on
Infrastructure REITs infrastructure (cell towers,
data centers, pipelines).
Indirect exposure by
financing public
Municipal Bond Funds
infrastructure projects via
municipal bonds.
Buying physical items (art,
wine, cars, stamps, etc.).
Collectibles and Art Direct Purchase
Requires expertise, storage,
insurance. Highly illiquid
Regulation of Alternative Investments
Even when they don't involve unique items like coins or art, alternative investments are
prone to investment scams and fraud due to the lack of regulations.
Alternative investments are often subject to a less clear legal structure than
conventional investments. They do fall under the purview of the Dodd-Frank Wall Street
Reform and Consumer Protection Act, and their practices are subject to examination by
the U.S. Securities and Exchange Commission (SEC).3
However, they usually don't have to register with the SEC. As such, they are not
overseen or regulated by the SEC as are mutual funds and ETFs.4 So, investors must
conduct extensive due diligence when considering alternative investments. In some
cases, only accredited investors may invest in alternative offerings.
Accredited investors are those with a net worth exceeding $1 million—not counting their
primary residence—or with an annual income of at least $200,000 (or $300,000
combined with a spousal income) in each of the two previous years. Financial
professionals who hold FINRA Series 7, 65, or 82 licenses may also qualify as
accredited investors.5
Advantages and Disadvantages of Alternative Investments
Pros
● May offer diversification benefits
● Often have higher return potential than traditional investments
● May offer protection against inflation
● May offer investors more specialty investment options
● May be less liquid and more difficult to sell in a hurry
Cons
● Often associated with higher fees and transaction costs
● Often have higher risk than traditional investments
● Often lacks transparency and may have reduced regulation
● May not be right for novice investors due to their complexity
● May be illiquid
Advantages
Because of their unique nature and differences from traditional markets, alternative
investments may have low correlations to traditional investments such as stocks and
bonds. Therefore, investors most often turn to alternatives to potentially help
diversify an investment portfolio and reduce overall portfolio risk.
Alternatives are considered riskier investments, and they often have the potential for
higher returns compared to traditional investments.
In addition, alternative investments come in different forms and structures, giving
investors the flexibility to choose the investment that best suits their preferences, risk
appetite, and investment goals. For instance, investors may favor certain
cryptocurrencies based on passive income opportunities.
Alternative investments may provide access to markets that are not available through
traditional investments. Not only may investors find this more interesting (i.e. a baseball
enthusiast may attach more passion to buying an autographed baseball), but that
investor may find it more difficult to sell that collectible because there are likely to be
fewer buyers, making the market less liquid.
This may be perceived as a benefit as this may enhance the price stability amongst
investors as there is less of an opportunity to panic sell: transacting quickly based on
emotion.
Disadvantages
Because of their limited accessibility, alternative investments often have higher fees and
expenses compared to traditional investments.
For example, private equity and hedge funds typically charge high management and
performance fees, which can significantly reduce investors' returns. Whereas many
brokers offer free trades of a number of stocks and bonds, many alternative investment
products come at a cost.6
As mentioned earlier, alternative investments are often illiquid which may be a benefit.
However, consider the situation where an investor needs to quickly sell a rare piece of
movie memorabilia because they need the cash. Because there may not be an active or
large market, they may not be able to easily or quickly sell the item without incurring
significant transaction costs or loss of value.
Because alternative investments may not be publicly traded, obtaining market data on
historical trends or pricing may be more difficult.
Whereas public companies must comply with many reporting rules, some alternative
investments may be subject to less regulatory oversight and have a higher risk of fraud,
misconduct, and other abuses. As mentioned above, alternative investments tend to
carry higher returns, though this is a function of their riskier nature.
Alternative investments are also more often complex. Some may have complex
structures and terms that can be difficult for investors to understand, increasing the risk
of making uninformed or inappropriate investment decisions. Others may have no
readily available market prices, making it difficult to determine their true value.
How To Invest in Alternative Investments
Getting started with investing in alternative investments is very different based on the
asset you're working with. Some may require substantial capital and research; others
may simply require a few clicks of a mouse button. Very broadly speaking, here's how to
get started with several types of alternatives.
● Private equity: Private equity investments typically involve buying shares in a
private company or a group of companies. Investors may participate in private
equity investments through private equity firms, venture capital funds, or
crowdfunding platforms.
● Real estate: Investors can invest in real estate through various means such as
buying rental properties, investing in REITs, or investing in real estate
crowdfunding platforms.
● Hedge funds: Hedge funds are typically available only to accredited investors,
and investors must have a high net worth and a substantial amount of investment
capital to qualify. Investors can invest in hedge funds through hedge fund
managers or brokers.
● Commodities: Commodity investments involve buying physical assets such as
gold, silver, oil, or agricultural products. Investors can also participate in
commodity investments through commodity trading platforms, ETFs, or mutual
funds.
● Art and collectibles: Investors can invest in art and collectibles through art
dealers, auction houses, or online marketplaces. Due to the uniqueness of these
goods, consider the reputation of the dealer when exploring avenues to trade.
● Cryptocurrencies: Investors can invest in cryptocurrencies through
cryptocurrency exchanges, brokers, or online platforms. Investors must often
deposit domestic currency into a digital wallet that will house the private keys and
currencies of that investor.
Note
As most alternative investments incur a transaction or processing fee, be mindful of
maintenance or one-time fees when pursuing alternatives.
Tax Implications of Alternative Investments
Because they represent an entirely different asset class compared to stocks and bonds,
many alternative investment industries have different tax rules. In addition, consider
how different alternatives may have different income streams (i.e. capital gain on the
sale of a rental property in addition to rent revenue).
Some alternative investments such as collectibles and art may not offer the same tax
deductions as traditional investments like stocks and bonds. In addition, collectibles
such as art or coins are explicitly defined by the IRS as a collectible, and net capital
gains are subject to a maximum 28% tax rate.7
FAST FACT
The alternative investment industry is expected to grow to $24.5 trillion in assets under
management by 2028.8 InvestmentNews. "Global Alternatives Market Set to Reach
$24.5T, Private Credit AUM to Double."
Cryptocurrency and other digital asset tax rules continue to evolve. Digital assets such
as virtual currency, cryptocurrency, stablecoins, and non-fungible tokens may incur
taxable transactions when selling the asset for fiat, exchanging the asset for goods or
services, or exchanging the asset for another digital asset. In addition, whereas
fluctuations in the value of the U.S. dollar would not incur a taxable event, fluctuations in
the value of digital assets often result in capital gains or losses.97
Some alternative investments such as real estate and certain types of energy
investments may offer tax-deferred or tax-free investing options. This may include 1031
exchanges and Opportunity Zone investments where investors can use proceeds from
the sale of an alternative asset to invest in a similar or specific asset with those
proceeds to avoid taxes.1011
As you embark on your alternative investment journey, consider talking with a financial
advisor in addition to a tax advisor to best understand how to protect your asset and
ensure maximum efficiency in protecting returns.
What Are the Key Characteristics of Alternative Investments?
Alternative investments tend to have high fees and minimum investment requirements,
compared to retail-oriented mutual funds and ETFs. They also tend to have lower
transaction costs, and it can be harder to get verifiable financial data for these assets.
Alternative investments also tend to be less liquid than conventional securities, meaning
that it may be difficult to value some of the more unique assets because they are so
thinly traded.
How Can Alternative Investments Be Useful to Investors?
Some investors seek out alternative investments because they have a low correlation
with the stock and bond markets, meaning that they may maintain their values in a
market downturn. Also, hard assets such as gold, oil, and real property are effective
hedges against inflation. For these reasons, many large institutions such as pension
funds and family offices seek to diversify some of their holdings into alternative
investment vehicles.
What Are the Regulatory Standards for Alternative Investments?
Regulations for alternative investments are less clear than they are for more traditional
securities. Although alternative investment vehicles are regulated by the SEC, their
securities do not have to be registered. As a result, most of these investment vehicles
are only available to institutions or wealthy accredited investors.
The Bottom Line
Alternative investments are investment options outside of traditional investments such
as stocks, bonds, and cash.
Alternative investments may include a wide range of assets such as real estate,
commodities, private equity, hedge funds, art, collectibles, or cryptocurrencies.
These investments are generally less liquid than traditional investments, though they
may boast diversification and higher returns compared to more popular forms of
investing.