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…Back in 2007, 65% of American adults reported investing in stocks…[yet] in
2016, only 52% said they had money invested in equities…so, where is all the money going? While there are no clear answers to this question, there are alternatives to the stock market which might be palatable to certain investors. We’ll explore these asset classes and ways in which even average investors might take advantage of their opportunities.
The comments above and below are excerpts from an article by Damian Davila (WiseBread.com) which has been edited ([ ]) and abridged (…) to provide a fast & easy read.
5 Types of Alternative Investments
While there is an ever-growing list of alternative investments, here are the five most common categories.
1. Private Equity
Unlike shares from publicly traded companies or exchange-listed mutual funds, shares of private equity investments aren’t available on a public exchange. Instead, private equity is only available through private companies that seek underperforming businesses, turn them around using their team of expert managers, and increase profitability of those businesses. Once the market value of the purchased business increases, the private equity firm sells that business and gains a percentage fee from the sale proceeds. Additionally, managers of private equity firms often gain an annual fee for providing their management expertise to acquired companies.
2. Venture Capital
A subset of private equity firms, venture capital companies focus on startups and small businesses that have a long-term growth potential. Venture capital is a great opportunity to secure much-needed financing for companies with very limited operational history. In exchange for that cash flow injection, startup founders and small business owners provide venture capitalists (also known as “angel investors”) a major say in most management decisions of the startup.
In recent years, some recipients of venture capital have turned into “unicorns” — companies with an estimated valuation of more than $1 billion — with Forbes listing American ride-sharing firm Uber and Chinese consumer electronics manufacturer Xiamoi in the number one and two spots, respectively.
Venture capitalists are the first to profit when a startup or small business is acquired by a larger company or becomes listed on the stock exchange through an initial public offering (IPO). Unfortunately, angel investing usually requires significant capital of your own, so it’s difficult for most investors to gain access to this investment class.
3. Hedge Funds
These are yet another subset of private equity firms. They’re called hedge funds because when they first started, they had the objective to limit — or hedge — investment risk through a series of financial vehicles and investment strategies. However, that definition no longer applies and hedge funds are known as aggressive, risk-seeking investment funds that typically use leverage to offer “alpha” (abnormal rate of return against a benchmark).
Like private equity and venture capital firms, hedge funds pool funds from a number of accredited and institutional investors. Unlike other private equity and venture capital firms, hedge funds focus on a much broader set of assets and investments strategies, including equity long-short, distressed assets, arbitrage, macro-trends, and managed futures. Like angel investing, hedge funds are often reserved for investors with significant capital.
4. Managed Futures
Wealth managers, mainly those of hedge funds, use futures (financial obligations for a buyer to purchase an asset or a seller to sell an asset at a predetermined future date) and options (rights to buy or sell an asset at expiration) to diversify among asset classes and mitigate the risk of an existing portfolio. Futures and options provide a way to diversity risk that isn’t available through investments in direct equity.
In addition to futures and options, a wealth manager could use other derivatives, such as forward contracts, swaps, and mortgage-backed securities to diversify a portfolio. All of these types of contracts are very complex and have been subject to scrutiny by several government agencies. For a primer on mortgage-backed securities and other derivatives, watch The Big Short.
5. Real Assets
These are firms that focus in the speculation of real assets. By using their expertise in a specific field, such as real estate, wine production, or art appraisal, these companies acquire tangible assets in the hope of gain — but with the obvious risk of loss. Lately, there has been an explosion in investment in luxury and collectible goods of all forms.
How Can You Invest in Alternative Investments?
You can invest directly as an accredited investor or through an exchange traded fund (ETF) or retirement account.
1. Accredited Investor
Generally, only institutional investors (organizations that invest on behalf of its members) or accredited investors (individual investors or entities that meet income, net worth, asset size, governance status, or professional experience requirements set by the Securities and Exchange Commission) have access to private equity, venture capital, and other types of alternative investments.
Some alternative investment firms may charge accredited investors a membership fee to be able to invest. For example, the Hawaii-based venture capital firm Hawaii Angels charges individual membership fees for out-of-state investors starting at $700 per year.
Chances are that you won’t meet the SEC requirements to become an accredited investor. For example, the SEC requires any natural person to have an individual or joint net worth of at least $1 million, or an individual income in excess of $200,000 in each of the two most recent years ($300,000 in case of joint income) and a reasonable expectation of sustaining the same income level in the current year. According to the latest data from the U.S. Census Bureau, the median household income stands at $53,889, which means there aren’t many of us who qualify.
2. Exchange Traded Fund
Individual investors not meeting the SEC requirements can leverage exchange-traded funds (ETFs) to gain exposure to capital invested in alternative investments. For example, the PowerShares Global Listed Private Equity Portfolio ETF and the Proshares Global Listed Private Equity ETF allow you to invest in private equity portfolios.
One key advantage of ETFs is their liquidity. Because they’re traded just like stocks, [however,] one potential drawback is that there are over 1,400 U.S.-based ETFs, making it difficult for individual investors to pick the “winners.”
3. Retirement Account
Your 401K or IRA may already offer you the option to gain exposure to some alternative investments. Many retirement accounts offer a real estate investment trust (REIT) within their available funds for plan holders. A REIT owns or invests in income-producing real estate assets, such as shopping malls, apartment buildings, and warehouses, and in real estate debt, such as mortgages and other types of loans.
Talk with your plan administrator to learn more about your full set of options in your retirement accounts. Some retirement accounts may already offer prospectuses of all funds available in the plan through an online platform that you can access after setting up your account.
The Bottom Line: Invest Carefully in Alternative Investments
All types of alternative investment firms seek extraordinary returns through their expertise within a specific field. A higher rate of return always comes with a higher level of risk, so make sure to only invest in alternative investments when you’re fully comfortable with that level of risk.
Conclusion
Depending on your tolerance for risk and total available investment fund, financial advisers suggest investing between 5% and 20% in alternative investments...and don’t forget to check the schedule of fees! Whenever evaluating whether an alternative investment is worthwhile, consider the total cost to determine whether or not those investments are suitable to you.