7 Types of Alternative Investments
Alternative investments are investments in asset classes that differ from traditional investment vehicles. Traditional investment vehicles include stocks, bonds and cash. Alternative investment classes include things like hedge funds, private equity, real assets and venture capital.
About Alternative Investments
The appeal of alternative investments is that they help you diversify your portfolio beyond the normal investment classes. They also have the potential to generate outsized returns compared with stocks and bonds.
On the other hand, these potential outsized returns to do not come for free. Instead, they have a substantial amount of risk. Investors need to determine whether the risk is worth the reward for a particular investment.
Alternative investments are generally less liquid than traditional investments. As a result, it is often harder to obtain an accurate valuation outside of a sale. While you can look up up-to-the minute pricing information with stocks and bonds, this is not often so with alternative investments.
Finally, alternative investments are often restricted to a certain class of investors called accredited investors. As a result, your average retail investor does not always have access to these types of investments. On the other hand, it is sometimes possible to gain access through things like mutual funds.
Types of Alternative Investments
There are several different types of these special investment classes and assets. We will run through some of these so you get a sense of what they are here:
1. Hedge Funds
Hedge funds are types of investment funds that use specialized trading strategies to invest in stocks and other traditional assets. As a result, they can help you achieve better diversification.
Their strategies often allow them to be less correlated with the performance of traditional markets. And great hedge fund managers can lead to exceptional performance.
Strategies that hedge funds use include macro trends, distressed assets, arbitrage, equity long-short and managed futures. Hedge funds often exploit market inefficiencies.
The hedge fund industry is currently valued at about $4.53 trillion.
2. Private Equity
Private equity is an alternative investment that entails the placement of investment funds into private companies. Because these are private and not public companies, you cannot buy public stock in them.
Generally, private equity companies raise money for private firms from institutional or noninstitutional investors. The company can raise this private capital at any stage of a firm’s lifecycle.
The private company returns the investment as the result of an exit event. Exit events include the private company going public or being bought out.
The private equity company takes management and performance fees for its services when the investment is returned.
The private equity industry is currently valued at about $9.8 trillion.
3. Venture Capital
Venture capital is an alternative investment that is a subset of private equity. It is the investment of funds in early stage or growth stage companies.
Venture capitalists raise money from both high-net worth investors and institutional firms. They then deploy that capital to a variety of private startup and growth companies. Average investors can now invest in early stage private companies as well. To learn more, check out our research on pre-IPO investing.
Venture capital investing is often highly risky but can lead to very high returns. As a result, you need to be a sophisticated investor to perform well in this field.
The venture capital industry is currently valued at around $51.6 billion.
4. Private Placement Debt
Just like there is private equity, another alternative asset is private placement debt. Unlike publicly traded bonds, private placement debt does not have to be rated by a credit rating agency.
Vehicles like mezzanine debt and promissory notes can be used to raise funds for a private company through debt. Unlike private equity, you won’t get the same size of outsized returns that you could expect with very high risk.
On the other hand, private placement debt can result in a steady stream of cash flows. Therefore, there can be less risk than private equity investments and subsets like venture capital.
5. Direct Investment: Private Companies and Startups
This alternative investment includes direct investment in startup and private companies, which makes for high risk and high reward investing.
After all, many startup companies fail. As a result, your entire investment could be at risk. Nevertheless, sometimes even retail investors are able to invest in this risky way.
When a private company seeks direct placements of funds in its company, it is often difficult to determine the right valuation. But again, with high risk come the potential high rewards if you directly invest in the next Google or Facebook.
6. Fund of Funds
A fund of funds invests in other alternative investment funds. This way, investors can gain instant diversification. A fund of funds can invest in different fund managers, investing strategies or asset classes in order to diversify its investment.
7. Real Assets
There are different real or tangible assets that you can invest in. These can include a variety of assets, such as…
- Commodities like oil and natural gas
- Precious metals like gold and silver
- Collectibles like art, wine, stamps, coins or baseball cards
- Rental real estate
- Agricultural land
Investors have several options when it comes to investing in real assets. You can invest directly by buying the tangible assets themselves, like a collector. Or you can invest in funds that purchase collections of these assets and distribute returns to investors in the funds.
For more information on investing in a particular tangible asset class, works of art, make sure to check out our article on investing in art here.
Concluding Thoughts on Alternative Investments
Not everyone can or should invest in alternative investments. But for certain investors, they can lead to high returns and satisfying portfolio diversification.
Whether you invest through private equity, a fund of funds, hedge funds or by buying tangible assets, these kind of investments can help lead to outsized performances.
About Brian M. Reiser
Brian M. Reiser has a Bachelor of Science degree in Management with a concentration in finance from the School of Management at Binghamton University.
He also holds a B.A. in philosophy from Columbia University and an M.A. in philosophy from the University of South Florida.
His primary interests at Investment U include personal finance, debt, tech stocks and more.