Alternative Investments 101: Should You Invest In Hedge Funds, Real Estate, Collectibles & More?

Picture of a classic sports car. Vintage cars and other collectibles are among the most profitable alternative investments
Rare, valuable collectibles, such as vintage sports cars, are among the best examples of alternative investments

When talking about investments, most people usually imagine stocks, bonds and other conventional assets.

However, there are many other not-so-conventional investment opportunities that are collectively referred to as “alternative investments.”

In this blog, we will cover what alternative investments are, typical examples, advantages and disadvantages and how you can invest in them.

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What Are Alternative Investments?

“Alternative investments” is a broad term for all investment opportunities that don’t fall under any of the conventional investment categories.

While traditional investments usually include stocks, bonds, cash assets and similar, alternative investments tend to be more complex and difficult to access for the average individual investor. They often require large capital and deep financial market knowledge which is why they are typically leveraged by institutional investors, investment banks and other wealthy individuals.

What Are The Different Kinds Of Alternative Investments?

If you are vaguely familiar with alternative investments, you’re probably linking them to assets such as private debt, but that’s only one of many examples. Here are the four most common alternative assets:

#1: Hedge Funds

Hedge funds are investment funds that pool capital from multiple individuals and organizations to invest in various assets — typically alternative ones — in an effort to bring as much revenue as possible to their clients.

In other words, hedge funds are similar to mutual funds in the way they operate. You simply give your money to someone else, they invest it for you and, if the investment was successful, charge you a commission for their services.

However, unlike mutual funds that are typically limited to investing in stocks and bonds, hedge funds can invest in almost anything they want. Their portfolios often include investments such as commercial real estate, financial derivatives, and other assets we’ll cover later on in this article.

Another point of departure between mutual and hedge funds is that hedge funds often rely on leverages — or borrowed funds — to amplify their investments and increase their returns.

Because hedge funds are largely driven by short-term profits, they are considered as very risky investments despite their profit potential.

Another downside of hedge funds is that they are virtually inaccessible to small individual investors as they typically only accept “accredited investors” as their clients. As defined by the Securities Exchange Commission (SEC), these accredited investors must have a personal income of at least $200,000 per year or a net worth of $1+ million.

#2: Venture Capital

Venture capital (VC) investing is the practice of investing money in early-stage startups or small businesses that show great earning potential exchange for a certain percentage of shares or profits.

In other words, venture capitalists support underfunded small companies and help them grow into well-established businesses, while the investors earn a share of their success.

In recent years, venture capital has been one of the most lucrative alternative investing opportunities. This is due to its early-stage nature as venture capitalists are often the earliest investors in promising businesses or projects. This entitles them to larger portion of the company’s future earnings at a relatively low price.

Venture investors can profit greatly if the company they invested in grows into something big in the future.

Take Uber — the largest ride-sharing service in the world. It was founded in 2009 and just four years later in 2013 it had raised a total of $272.8 million in venture capital funding from Google’s subsidiary fund GV Management.

Fast forward to 2021 when Uber is valued at over $85 billion, meaning that the original venture capital injected into the company turned into great profits for the original investors.

The downside of VC investing is that it is, once again, largely inaccessible to individual investors. To participate in VC funding, investors typically need to commit enough capital to a VC fund to meet the minimum investment requirements. These requirements can range anywhere from $100,000 to millions of dollars — a considerable amount of money for most individual investors.

The barriers to entry are quite high in this industry as the investments are typically measured in millions and tens of millions of dollars — especially when it comes to tech projects.

#3: Private Debt

Private debt investing is the practice of purchasing and owning another person’s or business’ debt instead of directly loaning them money.

Private debt investors purchase the ownership of mortgages, loans or company debt, which entitles them to get the interest on that dept until the debt matures.

Investing in private debt is fairly new, but it’s attracting more interest from institutional investors because it offers relatively high yields with lower risk than other alternative investments.

Because it is a fairly new concept, there is no established market for buying and selling private debt. Instead, investors find lenders with high-interest loans and then purchase them from the lender — or, if they’re lucky, from the borrower — at a discount.

As with many other alternative assets, private debt investing also carries risks. The most notable risk factor is default — a company’s or individual’s inability to fulfil their debt obligations.

For example, if you invest in someone’s mortgage loan or business loan and they fail to pay you back on time or at all — you will be at risk of losing your investment. Similarly to deposit-taking banks, private debt investors are also subject to regulatory control by government authorities, such as the SEC.

#4: Tangible Assets

“Tangible assets” is a broad term that covers all investment opportunities that physically exist in the real world, ranging from real estate to collectibles.

We are compiling them into one category because they all have a lot of features in common, including drawbacks and benefits.

The key driving force behind the value and the investment potential of all tangible assets is their rarity — whether we’re talking about office space in downtown Los Angeles, artwork by a famous artist, a vintage sports car or a bottle of Cabernet Sauvignon wine from 1992 valued at $500,000.

Some of these assets have enjoyed outstanding growth in value as investments over the years. For example, the value of the 1963 Ferrari 250 GTO has grown at an annual rate of 15.14% all the way to becoming the most valuable car ever sold, fetching $70 million at an auction in 2018.

By comparison, the S&P 500 index has grown at an average annual rate of 10.39% since 1963.

However, while tangible assets investment can have great profit potential, there are considerable caveats that make them risky.

Firstly, most tangible assets are not very liquid, meaning that it might be difficult for an investor to sell them for cash. This is especially true with commercial real estate and niche collectibles, which might require the investor to go through several potential buyers or auctions to sell the asset.

Secondly, tangible assets‚ especially collectibles, can be very difficult to objectively value. Unlike conventional assets, the monetary value of rare collectible items is not driven by the standard mechanics of financial markets. Instead, it depends on their rarity, significance and the subjective passion of the collectors. As a result, it may be difficult to represent these assets as portions of an investment portfolio.

Finally, tangible assets command more knowledge and personal commitment on behalf of the investor. In other words, you really have to know what you’re doing if you decide to invest in a rare collectible item.

In many cases, the individuals who invest in such assets consider it a hobby and have considerable background knowledge of their interest. This makes intangible assets even more inaccessible for individual investors who don’t share the same passion.

Funding a startup: a message on the photo holder. Startups are typically funded by venture capital — an alternative investment example
Venture capitalists profit from investing into promising businesses at their early stages

Alternative Investments Risks

The investment opportunities we’ve described are just the tip of the iceberg when it comes to alternative investments.

Nevertheless, whichever alternative investment type you consider, you’ll find that most of them share the same risks — but also the same benefits. Let’s start with the risks.

High Barriers To Entry

In the world of alternative investments, transactions are usually measured in tens, hundreds of thousands and even millions of dollars.

As a result, any individual investor who wishes to invest in such assets should be prepared to commit — and possibly lose — large amounts of money. In addition, there are various regulatory and cultural obstacles to becoming investing in alternative assets.

To a substantial extent, they are considered exclusive assets, reserved for high-net-worth individuals, certified investors and organizations — a difficult club to join for an individual investor.

Lack Of Regulation

Because alternative assets are very loosely defined as a category, they are equally loosely regulated by legislation — which can pose a considerable risk for individual investors.

Some assets, such as real estate, are regulated more than, say, the collectibles market — but they are still not as formally governed as the stock market.

Illiquidity

The poor liquidity that we’ve mentioned in our exploration of tangible assets equally applies to other alternative assets.

Such assets can be very difficult to quickly convert into cash — which is not typically a problem for the high-net-worth and institutional investors who often have considerable cash assets at their disposal.

However, for smaller individual investors, this illiquidity can pose a significant risk — especially during times of market volatility.

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Alternative Investments Benefits

Even though it may seem that alternative assets can offer nothing but risks, that’s not the case. Here are a couple of benefits that make them so desirable among high-end investors.

Low Market Correlation

Alternative investments’ low market correlation means that the value of these assets typically has a dynamic that’s opposite to the rest of the financial market.

In other words, they are not bound by the movements in the stock market and can grow in value even when the stock market tanks. As a result, investing in alternative assets can help you diversify your portfolio and counterbalance your losses during times of market slumps.

High Growth Potential

Alternative investing opportunities are as true to the classic investing formula of “high risk = high reward” as they can get. Even though they can be incredibly risky due to the combination of factors we described above, they can also be very profitable.

Ironically enough, their profitability stems from the same factors — low regulation, exclusivity and large capital at play. If you can afford to invest in alternative assets, you can benefit from their great profit potential.

Cash frozen in ice — an illustration for the illiquid nature of alternative investments
One of the biggest drawbacks of alternative investments is that they tend to be illiquid and can’t easily be converted into cash

Should You Invest In Alternative Assets?

Unless you’re an accredited investor with deep pockets or can afford to hire an accredited investor to manage your money for you, you should probably avoid alternative investments.

As lucrative as they may seem, alternative assets are not truly an alternative to conventional investments. Here’s why:

Most alternative investment are highly speculative in nature — that’s precisely why they can be so risky, yet so rewarding. Risk is fundamental to investing and there is no way to completely avoid it. What you should be mindful of, however, is the amount of risk you can afford to take on.

The reason why high-net-worth individuals and private investment funds are the primary investors in alternative assets is because they can afford to make risky, speculative investments. For them, conventional assets such as blue-chip stocks might simply not be profitable enough which is why they may look to supplement them with the more unconventional assets.

In other words, such investors don’t necessarily have to worry about long-term financial sustainability as they have already achieved it which gives them the freedom to experiment with their money.

However, if you’re an individual investor and you’re just starting to build your portfolio, you’re not exactly in a position to conduct such experiments. Instead, you should focus on building a solid, sustainable foundation for your investment portfolio — and the conventional assets, such as stocks, bonds and cash assets are best suited for this.

After all, the purpose of investing is to help you achieve your long-term financial goals such as an early retirement, a college fund for your children or a beach house. These goals are not something you should put at risk by making expensive, speculative investments.

That’s why it’s probably the best idea to avoid the complexities of alternative assets until you can afford to take the risk that comes with them.

Wrapping Up On Alternative Investments

As lucrative as alternative investments may sound to you, there is a reason why they are typically inaccessible to small individual investors.

Hedge funds, venture capital, private debt, real estate and collectibles command large capital because they are risky, illiquid and most of them are largely unregulated. And while those factors won’t stop institutional investors and high-net-worth individuals from investing in such assets, they can be too much to bear for an individual investor like yourself.

Fortunately, the conventional assets that are widely available to all investors can be just as helpful in achieving your financial goals. All you need to do is pick the assets you can afford to invest in, create an investment plan and stick with it.

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