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Sophisticated investors are often on the hunt for so-called “alternative investments,” those that aren’t publicly traded like stocks and bonds. These assets could include non-traded commercial real estate, private equity funds, sports teams and many others. To access them, you’ll often need to be an accredited investor and work with a private equity firm.
Why might investors be so hot for alternative investments? First, they may be undiscovered and offer attractive returns that others can’t access. Second, alternative assets may offer what investors call “non-correlated returns” – a fancy way of saying that they may perform differently from publicly traded assets, zigging when they zag – a helpful feature when diversifying a portfolio.
However not all alternative assets are the same, and many are just faddish collectibles whose value has no fundamental basis except for their popularity.
What makes alternative investments so popular
Many alternative assets may offer attractive and non-correlated returns. For example, off-market commercial real estate may deliver a steady stream of income as well as capital appreciation. And a private equity investment or a hedge fund may also outperform the market over time.
But outperforming the S&P 500 over time is difficult, and the few hedge funds or private equity funds that can do it consistently are rare. (The same is true in public markets, too – passive investing has historically won.) For example, many studies show that private equity as a whole underperforms a basic S&P 500 index fund once you include the (substantial) fees for investing in the funds and factor in the sometimes gigantic fees extracted by the private equity firms.
So why do alternative assets get such a strong push from financial advisors and asset managers? One key is understanding what’s happened to management fees over the last 20 years and more. They’ve compressed drastically, as you can see in the chart below, which shows the expense ratios for mutual funds and exchange-traded funds since 2005. Fees have plummeted.
This decline has left asset managers scrambling for a way to generate higher fee income. So alternative assets have become a new way for managers to once again charge high fees, now for their expertise in accessing non-public assets – even though they often don’t perform as well as a plain vanilla S&P 500 index fund, which is available to all investors at low cost.
What to watch out for when considering alternative investments
Investing in a well-positioned business or real estate may work out well or poorly, but it’s nonetheless an investment in an asset that could reasonably produce income over time. But many so-called alternative assets may be nothing more than fads that happen to be in favor, with their price supported by their current popularity and nothing more.
Legendary investors such as Warren Buffett and Charlie Munger advise investors to purchase assets that produce income rather than those where the value relies on sentiment alone. These latter “assets” may end up having no enduring value, with their price declining as soon as the public moves on to the next fad du jour. In other words: stick to income-producing investments. If an investment can increase its cash flow, its price will likely rise over time.
In contrast, speculations rely on the asset to become more popular to drive the price higher. So speculations depend on what’s called the “greater fool theory of investing” – the idea that to make money you need to sell it to someone who’s more optimistic about the asset than you are.
All this is not to say that you can’t make money on speculations – you absolutely can! – but you’re playing a dangerous game where the rug could be pulled out from you at any point. Sentiment may turn on a dime, and you could be left with a lot of worthless collectibles.
That’s exactly what we’ve just witnessed with the quick flame-out of non-fungible tokens (NFTs). In just a couple of years, the hot digital collectibles have become all but unsellable.
And it could become the case with the kinds of alternative investments in the list here. On top of it all, you’ll pay higher long-term capital gains on collectibles than on traditional investments.
10 top types of alternative investments
Art is the quintessential trophy asset, and it’s where the wealthy put the money they’ve made elsewhere (ahem, the stock market). The “blue chips” in this space are works from the “Old Masters,” but they cost a fortune to buy. And if you’re looking for the potential big gainers, you’ll need to have expertise here to find what’s going to be the next huge thing and avoid the potential forgeries, too. Add on the significant costs to get in and out of these assets, and it ends up being a game played primarily by the wealthy.
The best advice for art is to buy it because you love to look at it, not as an investment.
A home run baseball from Babe Ruth or Hank Aaron may retain its value, but one from that forgettable (and forgotten) player who hit a home run to win a World Series game? Sports memorabilia may be popular in its moment – exactly the right time to cash in for the lucky person who catches the game-winning ball by chance – but likely not for the one who buys it.
In the last 15 years, shoes have become a popular speculation for a segment of the population, particularly as shoe brands release limited editions to help stoke the fervor. This artificial supply cap may keep prices up while speculation runs hot, but the tendency will ultimately be for more and more limited editions and if well-heeled buyers don’t keep streaming in, prices will likely fall.
As for art and handbags (next), buy the shoes because you like them and will wear them.
Handbags from the likes of Louis Vuitton, Hermès and other European houses are marketed as pricey and limited-edition luxury goods. While some bags may hold their value for quite a while, and buyers emerge to bid up a rare piece, money to put in the bag is better than the bag itself.
The luxury watch world saw a huge run-up starting when the Federal Reserve slashed rates to near zero in March 2020 and liquidity flooded this market and others. But when rates began to rise in 2022, chronographs from the likes of Rolex, Patek Philippe and other high-end horlogers began to fall in price. While the price of luxury watches may rise from time to time, the real value here is their beauty and the social status of signaling that you have money to burn.
Beanie Babies are an old-school fad from the 1990s, and while many have retained their value, they still rely on demand from collectors. The value of these collectibles relies on new collectors emerging to continue to pay even more money for the stuffed toys. If collectors age out of this fad, Beanie Babies will become a fond but silly memory – as will the ability to profit from them.
Buffett and Munger have long warned investors against cryptocurrency, where their prices generally rely exclusively on sentiment rather than any fundamental asset or cash flow. While a few cryptocurrencies may end up retaining value if they become well-established (and not outlawed), literally thousands of existing cryptocurrencies are likely to become worthless.
Stamps are a fun relic of earlier times and places, and collecting cheap varieties can be a fun and even inexpensive hobby that can take you all over the world. But like Beanie Babies, to make money on stamps requires emerging collectors to pay even more than existing ones. And that requires a stream of new collectors to actually emerge, or at least wealthier ones.
The rarest coins continue to fetch money that ranges into the millions of dollars, so there seems to be plenty of demand at the high end. But like many speculative investments, collecting coins remains a relatively niche hobby that requires an influx of new money if you’re looking to profit. Again, that doesn’t mean you can’t make money here, but the upside relies heavily on the optimism of the next buyer.
The aesthetic pleasure that you get from a vintage car can be a real joy, as you motor down the road and consider the elegance of a bygone era. Or maybe you just like to rev a throaty engine and let a muscle car live up to its name. However you like to enjoy your vintage car, buy it because you love it, not because you intend to sell it for more.
Buying alternative assets such as these could seriously hurt your wealth, even while investors have proven investments such as S&P 500 index funds that have a strong record of returns. And you don’t have to do all the research work as you would if you bought individual stocks.