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When it comes to investing, most people think of securities like stocks and bonds. These investments, along with cash, are considered traditional investments and make up the bulk of retirement portfolios for most investors. But another category known as alternative investments also exists and has grown significantly in recent years.
Here’s what you should know about alternative investments and how they can diversify a portfolio.
What are alternative investments and how do they work?
Alternative investments fall outside the traditional investment classification of stocks, bonds and cash. Alternative investments include a broad range of assets but typically include real estate, commodities, private equity and hedge funds.
Alternative investments tend to have the following characteristics:
- Low liquidity – not as easy to sell or convert to cash.
- Higher fees – expenses tend to be higher than for traditional investments.
- Complex structure – some alternative investments can be complex and may only be available to accredited investors.
- Less regulation – alternative investments are subject to the same regulatory requirements as traditional investments, such as mutual funds or ETFs.
- Potentially low correlation – alternative investments may not be correlated with traditional assets, making them an attractive way to diversify portfolios.
Types of alternative investments
Real estate is one of the largest asset classes and allows investors to profit from holding physical properties or securities such as real estate investment trusts (REITs). Real estate investments can generate income for investors from rental payments as well as capital gains if a property appreciates in value.
Commodities are another type of alternative investment and include natural resources such as oil, natural gas, gold and various agricultural products. Commodity prices often respond to changes in supply and demand for the underlying commodity.
Investors may invest in commodities in a variety of ways. There are many ETFs that track the performance of various commodities, but you can also use derivatives or directly hold a commodity to profit off of price changes.
Private equity involves putting money into a private company or a start-up, which is known as a venture capital investment. Private equity may sound similar to investing in stocks, but private companies aren’t publicly traded. A private equity fund may work closely with the companies it invests in, helping to form a strategy and influencing capital allocation decisions.
Private equity funds are typically only available to institutional investors and high net worth investors. The fees for these funds can be substantial, but some are able to outperform traditional stock market indexes by a wide margin.
Hedge funds may invest in a combination of traditional and alternative investments and may use strategies such as shorting or derivatives in the management of their funds. Hedge fund fees can vary from one fund to another, but helped popularize the “2 and 20” fee structure, where investors paid a 2 percent management fee each year and 20 percent of the fund’s profits.
Hedge funds are only available to institutional investors and high net worth individuals.
Collectibles are an alternative asset that covers a broad range of items including:
- Trading cards
- Vintage cars
Investors who hold collectibles are hoping to sell their items for a higher price in the future. That’s the only way to profit off a collectible since they don’t generate income in the form of dividends or interest while you hold them.
Alternative investments can be a way to add diversification to your portfolio if the assets have a low correlation with traditional investments like stocks and bonds, meaning they tend to move in opposite directions. But alternative investments often have low liquidity and high fees, so they shouldn’t make up a significant portion of your portfolio.