Alternative investments have been a fixture in institutional investing for decades. Now they are becoming much more accessible to individual investors and new categories of alternatives are emerging. Learn what they are.
What Are Alternative Investments?
No authority explicitly defines alternative investments – not the SEC, FINRA, nor the IRS. Consequently, alternative investments are defined less by what they are and more by what they are not, which makes the definition somewhat ambiguous.
In a broad sense, alternative investments are investments that fall outside the realm of regulated public securities such as stocks, bonds, mutual funds, and ETFs. That means public securities are generally considered traditional investments, and non-public, or private, investments are considered to be alternatives.
That means certain types of assets can be seen as either traditional investments or alternatives based on whether they are available in a publicly-traded instrument or not. Shares of stock in a public company, for example, are traditional, while shares of stock in a private company are alternative. To distinguish the two, the industry refers to stock in private companies as private equity or venture capital.
A similar situation occurs with real estate. Most Real Estate Investments (REITs) are private investments, but some are publicly traded REITs. Private real estate trusts are considered alternative investments, but real estate that is held in a REIT that trades on the New York Stock Exchange can be seen by some as a traditional investment security.
For decades, institutions and accredited investors have participated in alternative investments that were not available to the general public. These are well established and include:
- Hedge funds
- Private equity
- Real Estate
- Managed futures
- Venture Capital
- Complex structured products
In addition, a new array of alternative investments are now available to everyone. These include:
- Bitcoin and cryptocurrencies
- Crowdsourced investments in startups
- Fractionalized art and real estate
With the above list, there are questions about whether some assets should be considered alternative investments, but not because there is a question about whether they are public or private. The question instead is whether they actually represent investments at all, and some people do not view them as such.
Alternative investments used by institutions are big business. According to alternatives research firm Preqin, as of January 2022, Managed alternative funds hold more than $13 trillion in assets. Preqin further predicts that assets will expand to $23 trillion by the end of 2026. Institutional investors such as pension funds typically hold an average of about 20% of their assets in alternatives. Bear in mind that these numbers don’t include cryptos or other public alternatives, which now represent an additional $2-3 trillion in value.
Alternative Asset Regulations
Assets are essentially considered to be alternatives when they do not conform to the Securities Acts of 1933 for equities or the 1940 Act for funds, and therefore cannot be offered to the public. Thus, if you start a fund to invest in private equity shares, your fund would not meet the requirements of the 1940 Act and would thus be considered a private (or hedge) fund, making it an alternative investment.
In 2016, Congress passed the JOBS Act, which opened the door to crowdsourcing and fractional investments up to certain limits, which could be marketed to the public. This now brings some private equity and venture capital deals into the public domain for all investors.
The important thing to understand about securities regulations is that they are not written to include or exclude any particular asset class. They are written to stipulate what can be offered to the public based on risk, size, reporting requirements, disclosures, etc. So, shares of stock can be either regulated or alternative (non-regulated) depending on whether they represent equity in a company that complies with the regulations (a public company) or one that does not (a private company). Therefore, listed stocks are traditional investments, while stock in a non-public company is either private equity or venture capital, which are alternatives.
Note: By law, private investments cannot be advertised to the public, so companies offering such investments must require that interested parties first attest to their accreditation status, and sometimes that will even involve providing proof. It may seem snooty, but firms are simply complying with the law.
8 Alternative Asset Classes
The following asset classes are among those considered to be alternative investments:
1. Venture Capital
Venture capital funds provide capital to startup companies.
2. Hedge Funds
Hedge funds are often identified as an asset class though, in reality, they are an investment vehicle or structure (like a mutual fund) that contains one or more asset classes. Some hedge funds invest in alternative assets while others invest in public equities but do not meet the requirements of the 1940 Act.
3. Private Equity
Shares of any private company constitute private equity. So venture capital is actually a form of private equity but private equity funds focus more on leveraged buyouts, corporate restructurings, and investments in late-stage startups that are beyond the venture capital stage but still not yet public.
4. Managed Futures
This refers to funds that actively engage in futures trading.
5. Real Assets & Collectibles
Real assets can include precious metals and collectibles such as art, wine, or classic cars.
6. Real Estate
Real estate investments can cover a wide range of properties such as residential, commercial, storage, warehouse, retail, resort, and more. In addition, there are investments available in farmland, grazing land, and timber.
7. Complex Structured Products
These are large financial projects such as international financing arrangements or the building of a large construction project such as a stadium complex or a nuclear plant.
8. Digital Assets
Digital assets are the newest alternative investment category. They include cryptocurrencies, NFTs, and metaverse investments.
Advantages & Disadvantages of Alternative Investments
- Diversification: Alternative investments are touted mostly for their ability to complement a stock portfolio by providing independent characteristics that can improve the overall risk-reward of the portfolio. It is widely acknowledged that blending non-correlated assets in a portfolio can lead to more efficient growth and lower volatility.
- Alternative characteristics: Alternatives can offer characteristics not necessarily found in stocks, such as higher income, less sensitivity to the economy, more favorable tax treatment, and lower volatility.
- Exceptional growth opportunities: Some alternatives are new and may offer growth opportunities greater than stocks.
- Greater choice: Alternatives provide investors with more choices to find investments that have the right characteristics and meld with their objectives.
- Liquidity: Many alternatives have no secondary markets and cannot be liquidated for years.
- Often restricted to accredited investors: Smaller investors are shut out from private investments that are restricted to accredited investors only.
- Less history: Some alternatives have relatively little price history compared to traditional equities.
- Fewer investor protections: Stock brokerages offer insurance through the Securities Investor Protection Corporation, which protects investors against their broker going bankrupt. Alternatives do not generally offer this type of insurance.
- More complicated: Alternatives can be much more complicated. Some come with thick offering memorandums that investors have to wade through and many need to be assessed and evaluated on different parameters than stocks.
Alternative Investment Examples
There are way more alternative investments than there are listed public securities and they range in size from crowdsourced start-ups raising a few hundred thousand dollars to multi-billion-dollar hedge funds.
Some examples of prominent alternative investment entities in different categories are:
- Venture Capital: Sequoia Capital; Andreessen Horowitz; Tiger Global Management; and Greylock Partners.
- Real estate: Blackstone Group, Inc.; Artemis Realty Partners; Starwood Capital Group; and Oaktree Capital.
- Private Equity: KKR & Co.; Carlyle Group; Vista Equity Partners; and TPG Capital.
- Crowdsource companies: Republic; Start Engine; Indiegogo; and SeedInvest Technology.
- Digital assets: Coinbase; Binance; BlockFi; and OpenSea.
Note: Because these companies cannot advertise private investments, they do not post information on those investments on their websites. Prospective investors essentially have to seek them out or connect with them through a licensed investment Advisor.
Alternative investments, already well established among institutional investors, are now becoming more available to individual investors. While they offer more choice, diversification benefits, and the potential for high growth, they are less liquid and often more complicated than public equities. Alternatives are likely to expand much further in the coming years and may provide attractive options for investors willing to learn more about them.
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