Understanding Alternative Investments

What is an ‘Alternative Investment?’

An alternative investment is an asset that is not one of the conventional investment types, such as stocks, bonds and cash. Most alternative investment assets are held by institutional investors or accredited, high-net-worth individuals because of the complex natures and limited regulations of the investments. Alternative investments include private equity, hedge funds, managed futures, real estate, commodities and derivatives contracts.

Breaking Down ‘Alternative Investment’

Many alternative investments have high minimum investments and fee structures compared to mutual funds and exchange-traded funds (ETFs). There is also less opportunity to publish verifiable performance data and advertise to potential investors. Most alternative assets have low liquidity compared to conventional assets. For example, investors are likely to find it considerably more difficult to sell an 80-year old bottle of wine compared to 1,000 shares of Apple, due to a limited number of buyers.

Investors may have difficulty valuing alternative investments due to transactions often being unique. For example, a seller of the extremely rare 1933 Double Eagle $20 gold coin may have difficulty determining its value, as there are only 13 known to exist as of 2016. Alternative investments are prone to investment scams and fraud due to their unregulated nature, therefore it is essential that investors conduct extensive due diligence.

Alternative Investments for Diversification and Hedging

Alternative investments typically have a low correlation with those of standard asset classes, which makes them suitable for portfolio diversification. Because of this, many large institutional funds such as pensions and private endowments have begun to allocate a small portion of their portfolios, typically less than 10%, to alternative investments such as hedge funds. Investments in hard assets such as gold and oil also provide an effective hedge against rising inflation, as they are negatively correlated with the performance of stocks and bonds.

Alternative Investment Costs and Tax Considerations

Although alternative assets may have high initial upfront investment fees, transaction costs are typically lower compared to conventional assets, due to lower levels of turnover. Alternative investments held over a long period may result in tax benefits, as investments held longer than 12 months are subject to a lower capital gains tax in comparison to shorter-term investments.

Accessing Alternative Investments through ETFs

While the majority of retail investors may have limited availability to alternative investment opportunities, real estate and commodities such as precious metals are widely available. ETFs now provide ample opportunity to invest in alternative asset categories that were previously difficult and costly for the retail investor to access. Investing in ETFs that have exposure to alternative assets has been mixed. As of June 2016, real estate ETFs have a five-year annualized return of 9.42%, while investing in energy commodities has returned negative 21.27%. The Standard & Poor’s 500 index (S&P 500) ETF returned 11.67% over the same period.

Alternative Asset

An alternative asset is any non-traditional asset with potential economic value that would not be found in a standard investment portfolio. Due to the unconventional nature of alternative assets, the valuation of some of these assets can be difficult.

Breaking Down ‘Stock Market’

For most people, examples of alternative assets would include art and antiques, precious metals, fine wines, rare stamps and coins, and sports cards and other collectables. However, there are also more traditional alternative assets including hedge funds, venture capital-related projects and infrastructure. In either case, alternative assets tend to be less liquid than traditional investments. Thus, investors who favour alternative assets may have to consider a longer investment horizon.

Portfolio Investment

A portfolio investment is a hands-off or passive investment of securities in a portfolio, and it is made with the expectation of earning a return. This expected return is directly correlated with the investment’s expected risk. Portfolio investment is distinct from direct investment, which involves taking a sizable stake in a target company and possibly being involved with its day-to-day management.

Breaking Down ‘Portfolio Investment’

Portfolio investments can span a wide range of asset classes such as stocks, government bonds, corporate bonds, Treasury bills, real estate investment trusts (REITs), exchange-traded funds (ETFs), mutual funds and certificates of deposit. Portfolio investments can also include options, derivatives such as warrants and futures, and physical investments such as commodities, real estate, land and timber.

The composition of investments in a portfolio depends on a number of factors. Some of the most important include the investor’s risk tolerance, investment horizon and amount invested. For a young investor with limited funds, mutual funds or exchange-traded funds may be appropriate portfolio investments. For a high net worth individual, portfolio investments may include stocks, bonds, commodities and rental properties.

Portfolio investments for the largest institutional investors such as pension funds and sovereign funds include a significant proportion of infrastructure assets like bridges and toll roads. Portfolio investments for institutional investors generally need to have very long lives so that the duration of their assets and liabilities match.

Impact of Risk Tolerance, Age and Time Horizon

The investments that are made in a portfolio are dependent on the investor’s circumstances. Those with a greater risk tolerance may favour investments in stocks, real estate, international securities and options, while more conservative investors may opt for government bonds and the stocks of large well-known companies.

These risk preferences should also be weighed against the investor’s goals and time horizon. A young person saving for retirement may have 30 years or more to save but isn’t comfortable with the risks of the stock market. This individual may want to favour a more conservative mix of portfolio investments despite the long time horizon. Conversely, individuals with high risk tolerances may want to avoid large allocations to riskier growth stocks if they are nearing retirement age. A progression to a portfolio of more conservative investments is generally recommended as an investment goal nears.

Portfolio Investments for Retirement

Investors saving for retirement should focus on a diversified mix of low-cost investments for their portfolios. Index funds have become popular in individual retirement accounts (IRAs) and 401(k) accounts due to their broad exposure to a number of asset classes at a minimum expense level. These types of funds make ideal core holdings in retirement portfolios. Those wishing to take a more hands-on approach may tweak portfolio allocations by adding additional asset classes such as real estate, private equity and individual stocks and bonds to their portfolio mix.

Chartered Alternative Investment Analyst (CAIA)

A professional designation is given out by the Chartered Alternative Investment Analyst Association to establish an educational standard for individuals that specialize in the area of alternative investments (such as hedge funds, venture capital, private equity and real estate investment).

To receive the designation, individuals must have at least one year of professional experience, a U.S. bachelor’s degree and must pass two levels of curriculum that include topics ranging from qualitative analysis, trading theories of alternative investments, to indexation and benchmarking.

Breaking Down ‘Chartered Alternative Investment Analyst (CAIA)’

Because the realm and scope of alternative investments are dramatically different from conventional investments such as stocks, bonds, mutual funds and exchange-traded funds, a specific designation was necessary to distinguish those individuals who are best qualified in dealing with this class of investments.

Similar to the Chartered Financial Analyst designation, possessing the CAIA designation provides individuals with access to jobs, member chapters and sources of education.

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