Most investors start their investing journey with a mix of conventional categories such as stocks, bonds, and cash instruments. A large number of publicly traded funds – ETFs, CEFs and mutual funds – allow for easy diversification across those traditional assets. Yet, over the past few decades, a universe of alternative investments – those that do not fall into one of these conventional categories – has been on a steady rise.
Many institutions such as university endowment funds, pension funds and family offices have embraced alternative investments and have been increasing allocations to them over the years.
While traditionally aimed at institutional or accredited investors, alternative investments have become accessible to retail investors via alternative funds and with the help of some legislation in recent years.
What are alternative investments?
Alternative investments are assets that don’t fall into the traditional categories. Some of the main alternative investment categories are listed below with brief descriptions.
Private Equity (PE) – capital invested in a company or other entity that is not publicly listed or traded. Private equity firms buy established or deteriorating companies and streamline operations to increase revenues. Private equity firms mostly buy 100% ownership of the companies in which they invest.
Venture Capital (VC) – a form of private equity and a type of financing that investors provide to startup companies and small businesses. VC investments are divided by the stage of the invested companies. The earlier the stage, the riskier the investment, but higher the potential rewards. These include Pre-Seed (early business development), Seed (business is looking to launch its first product), Early Stage (business is ramping up production), and Late Stage (business is expanding and is likely to go public next). Venture capital funds manage pooled investments. Angel investors are high net-worth individuals who may act as venture capital firms.
Hedge Funds – limited partnership of private investors whose money is managed by professional fund managers who use a wide range of strategies, including leveraging or trading of non-traditional assets, to earn above-average investment returns. Common hedge fund strategies depend on the fund manager and include equity, fixed-income, and event-driven goals. Many quantitative hedge funds rely on technology to execute high-frequency and algorithmic trading strategies. Some of the most common general types include Macro funds that attempt to profit from broad market swings caused by political or economic events; Equity funds that invest in global or single country stocks; Relative Value funds that seek to exploit temporary differences in the prices of related securities, taking advantage of price or spread inefficiencies, and Activist funds that aim to invest in businesses and take actions that boost the stock price by pressuring the board of directors to take certain operational and financial actions. Hedge funds use riskier strategies, leverage assets, and invest in derivatives such as options and futures.
Private Real Estate – a professionally managed fund that invests in real estate. Office buildings (high-rise, urban, suburban, and garden offices); industrial properties (warehouse, research and development, flexible offices, or industrial space); retail properties, shopping centers (neighborhood, community, and power centers); and multifamily apartments (garden and high-rise) are the most common private equity real estate investments. There are also niche property investments such as senior or student housing, hotels, self-storage, medical offices, single-family housing to own or rent, undeveloped land, manufacturing space, and more. Overall, real estate is the single largest asset class in the world. Certain tax-advantaged strategies in real estate involve 1031 Exchanges, Delaware Statutory Trusts (DST), and Qualified Opportunity Zones (QOZ).
Private Credit – loans provided by a non-bank lender. Private credit can be extended to small and medium-sized businesses, consumers, and real estate companies, as rescue finance or specialty lending / finance. Specialty finance is high-risk credit such as plane leasing and litigation finance. Generally, private credit is divided into categories by credit quality, similar to the public credit markets, where the highest risk commands the highest yield.
Source: Schroders
Managed Futures – a portfolio of futures contracts is actively managed by professionals. Managed futures provide portfolio diversification by offering exposure to asset classes that help mitigate portfolio risk in a way that is not possible in direct capital investments like stocks and bonds. The futures contracts used in funds can be written on equity or fixed-income indices, currency pairs, interest rates, and others, but the most popular underlying type is commodities.
Digital Assets – a digital or virtual currency secured by cryptography, which makes it nearly impossible to counterfeit or double-spend. It is a form of digital asset based on a network that is distributed across a large number of computers. This decentralized structure allows them to exist outside the control of governments and central authorities. Investment risks include user risk, regulatory risks, management risk, and high volatility. Other digital assets that could be alternative investments include tokens and tokenized assets, nonfungible tokens (NFTs), and certain types of digital media.
Collectibles can also offer diversification from traditional assets. Art, classic cars, wine, antique or historical objects, stamps, coins, sports cards and memorabilia, militaria, and pop art are all examples of collectibles. Unique risks for this asset class include subjectivity, uniqueness, illiquidity, counterfeits, difficult price discovery, and potential for deterioration or destruction. However, recently launched funds and marketplaces have allowed pooled or fractional investments in art, wine and other collectibles that mitigate some of the above risks.
Structured products are pre-packaged investments that normally include assets linked to interest plus one or more derivatives. These products may take traditional securities such as a single or an index of equities or bonds and replace the usual payment features with non-traditional payoffs. Structured products often include risk hedges such as guarantee of principal at the maturity date in exchange for sacrificing some upside of returns.
Just like traditional investments, alternatives vary greatly in their investment strategies, risk/reward characteristics, as well as their objectives in terms of growth, income, principal protection, and tax advantages, or a combination of these. The chart below represents a larger subset of alternative assets that today’s investors have access to.
Who can invest in alternatives?
Most alternative investments require an accredited or qualified investor status.
Who is an accredited investor?
An accredited investor is a person or entity with exclusive access to complex, loosely regulated and often opaque investments like hedge funds, leveraged buyouts and startups. To qualify as an accredited investor, according to Rule 501 of the Securities Act, a person must meet one of the below tests:
Have an annual income of at least $200,000 (or $300,000 for joint income with a spouse) for the last two years with the expectation of earning the same or higher income in the current year
Have a net worth exceeding $1 million, either individually or jointly with their spouse, excluding the value of primary residence
Be a “knowledgeable employee” of the fund, with respect to investments in a private fund, or hold certain professional certifications, designations, or accreditations
Who is a qualified investor?
A qualified investor is a category of investors that are exempt from the provision of the Investment Advisers Act of 1940 that prohibits private investment funds from charging performance-based fees.
A qualified investor can be one of the following:
A natural person who, or a company that, immediately after entering into the contract has at least $1 million under the management of the investment
A natural person who, or a company that, the investment adviser entering into the contract (and any person acting on his behalf) reasonably believes, immediately prior to entering into the contract, either:
Has a net worth (together, in the case of a natural person, with assets held jointly with a spouse) of more than $2 million, or
Is a qualified purchaser as defined in section 2(a)(51)(A) of the Investment Company Act of 1940 (15 U.S.C. 80a-2(a)(51)(A)) at the time the contract is entered into
A natural person who immediately prior to entering into the contract is:
An executive officer, director, trustee, general partner, or person serving in a similar capacity, of the investment adviser, or
An employee of the investment adviser (other than an employee performing solely clerical, secretarial or administrative functions with regard to the investment adviser) who, in connection with his or her regular functions or duties, participates in the investment activities of such investment adviser, provided that such employee has been performing such functions and duties for or on behalf of the investment adviser, or substantially similar functions or duties for or on behalf of another company for at least 12 months
Why alternatives and where do they fit into your portfolio?
While alternative investments are certainly not for everyone, opportunities exist in this space for the patient investors who do their homework. The main considerations are listed below.
| Pros | Cons |
|---|---|
| Potential higher return opportunity | Less regulation and less transparency than traditional investments |
| Narrow specialization of the investment managers | Concentrated portfolios |
| Diversification – relatively low correlation of returns with those of traditional investments | Limited historical risk and return data |
| Lower volatility than traditional investments | Liquidity Risk – restrictions on redemptions (i.e., “lockups” and “gates”) |
| Some alternatives may offer tax advantages | Unique legal and tax considerations |
| Often focused on inefficient markets | Higher fees, often including performance or incentive fees |
| Higher minimums to invest |
How can Eureka help with alternative investments?
Top 5 questions that investors should ask about any investment, but especially in case of alternatives:
Do you understand the investment?
Successful investors always get their questions answered before investing. Read the prospectus and disclosures and ask investment sponsors and your financial advisor if you still have questions.
How do the risks compare with the potential rewards?
All investments have inherent risks. What are the risks of this potential investment: market under-performance, loss of capital, liquidity, execution, regulatory, or anything else? Are these risks worth the potential rewards? Make sure you’re comfortable before you invest.
Is the seller licensed?
Check the background or have your trusted advisor do that for you.
A broker’s background and qualifications are available for free on FINRA’s BrokerCheck website
The Investment Adviser Public Disclosure website provides information about investment adviser firms registered with the SEC and most state-registered investment adviser firms
The SEC Action Lookup – Individuals allows you to look up information about certain individuals who have been named as defendants in SEC federal court actions
Is the investment registered?
Any offer or sale of securities must be registered with the SEC or exempt from registration. Investors can check by using the SEC’s EDGAR database.
The now defunct FTX’s native digital token was never registered, and the rest is history.Where can you turn for help?
Eureka Wealth Solutions should be your first point of contact. If you have further questions or concerns about an investment, please contact the SEC, FINRA, or your state securities regulator for help.
Here’s why we’re here – as part of our comprehensive Financial Planning, Eureka Wealth Solutions will:
Help answer all the questions above
Determine a potential need and opportunities in investment and tax planning
Provide due diligence on investments and sellers
Allow clients to take advantage of lower fees, lower investment minimums, or access to investments that are not available outside of the advisor channels
LEGAL DISCLAIMER. PLEASE READ CAREFULLY.
PRIVATE PLACEMENTS. Information presented on this page is not an offer to sell or a solicitation of an offer to purchase an interest in any entity or investment vehicle. Any such offer or solicitation will only be made through formal offering materials. This information also does not constitute accounting, tax or legal advice. Certain investment opportunities discussed herein may require you to be an accredited or qualified investor, as defined by the SEC. To verify your status and identity and to comply with federal money-laundering laws, investors may be required to provide certain personal information and proof of identity.
RISK. Past performance is not necessarily indicative of future results. All investments carry significant risk and all investment decisions of an individual remain the specific responsibility of that individual. The value of investments and their income may increase or decrease, and a loss of principal – including all principal – may occur. Securities purchased through private placements typically fall into the category of alternative assets – investments that often have a low correlation to public markets and offer essential diversification to portfolios dominated by traditional stocks and bonds. However, private placements generally are highly illiquid, and are not subject to public disclosure obligations. Early-stage investments involve substantial risk of loss and are not suitable for all investors. All investors are advised to fully understand all risks associated with any kind of investing they choose to do.
