IBKR Podcasts’ Cents of Security, Episode 43, “The World of Alternative Investments”, discusses the newfound potential of alternative investments in today’s marketplace, challenging the notion that conventional investments are always in the spotlight. Danielle Labotka, Ph.D, Behavioral Scientist for Morningstar, discusses how investors often look at alternative investments to diversify their portfolio, or because there are some high returns that may be associated with these types of investments. Yet, Dr. Labotka cautions investors may want to be careful with alternative investments because they are costly and perhaps even riskier due to less transparency and liquidity.
Considering, although unconventional, carrying more risk with fewer regulations, one wonders, can investments in art, real estate and other nontraditional assets be helpful in building wealth? The jury’s still out, and, of course, dependent on the asset, but research has shown that investors are interested in this newfound potential, and most certainly motivated by returns.1
Understanding Alternative Investments
An alternative investment is a broad term that encompasses any asset that isn’t stocks, bonds, or cash. These kinds of investments are illiquid, meaning they aren’t easily sold or converted into cash, and consequently, carry more risk with less transparency and fewer regulations.
Alternative investments also have a low correlation to standard asset classes. When market conditions change, for example, alternative assets do not necessarily move in the same direction as other (more traditional) assets; their market determinants are not always parallel.
Common Types of Alternative Investments
Private Equity
Capital investment made into private companies, or those not listed on a public exchange. Includes venture capital, growth capital, and buyouts.
Private Debt
Investments that are not financed by banks or traded on an open market (e.g., a firm raises capital by selling bonds, bills, or notes to individuals and entities, who then become creditors with the promise of repayment with interest).
Hedge Funds
Investment funds actively managed for a limited number of investors and institutions that trade relatively liquid assets and employ various investing strategies, methods and tools (like short selling, derivatives, swaps and arbitrage) with the goal of high returns. Usually require a high minimum investment and are managed by professionals charging management and performance-based fees.
Real Estate
Real assets. Any and all investments in “real property” (i.e., land, and things affixed to land). Includes commercial and residential properties.
Commodities
Real assets, mostly natural resources. Includes agricultural products, oil, natural gas, and precious and industrial metals. Exchange-traded commodities are quoted in specific lots of a specific quality for specified delivery, and usually also trade in forward, futures and options contracts.
Art and Collectibles
Physical items purchased and maintained with the hope the value of the items will appreciate over time. Includes fine art, rare wines, vintage cars, mint-condition toys, stamps, coins, baseball cards, etc.
Structured Products
Usually involve fixed income markets and derivatives. Specifically, pre-packaged investments that normally include interest plus one or more derivatives.
Digital Assets
Anything minted and exchanged on a blockchain. Includes cryptocurrencies, non-fungible tokens (NFTs), stablecoins and security tokens.
Why Alternative Investments?
Alternative investments offer a way for investors to diversify their portfolios beyond traditional stocks and bonds. These kinds of investments can be particularly appealing due to their potential for higher returns and lower correlation with the stock market; they offer unique opportunities that can play a crucial role in enhancing the overall performance of an investment portfolio.
Additionally, alternatives are often considered for their access to private markets, hedging opportunities, and unique investment strategies. Private markets – or unlisted securities – provide opportunities to invest in companies and assets that aren’t publicly traded, and some investments, like commodities or real estate, can even act as effective hedges against inflation and other macroeconomic factors. Sophisticated investment strategies, like leverage and derivatives, can also be appealing due to their trading techniques aimed at outperforming the broader market.
Things To Consider
It’s important to note that investing in alternatives requires careful consideration; these kinds of investments come with unique risks, including liquidity constraints, higher fees, and *less transparency than traditional investments. To quote Dr. Labotka,
“it’s important to slow down and consider how these investments work with your current needs and also align with your goals.”
Take the time to evaluate how much you know about the alternative investment you’re interested in before you invest. Specifically, do you know what the tax structure is? What the tax benefits are or aren’t? What the risks are? Questions like these are questions you must know the answer to. You must be able to *define the investment, such as by taking the time to do your research about the product.
Motivation is also important. How does your motivation fit into your long-term goals? Are you simply interested in the potential for hot returns or are you looking to bring more diversification to your portfolio? Your answer to this question will determine your approach and set the stage for your individual risk tolerance.
Understanding the underlying risks, including liquidity constraints, market volatility, and regulatory issues, is crucial. It’s essential to conduct thorough research and consider consulting with a financial advisor. Moreover, given the long-term nature of many alternative investments, investors should be prepared for holding periods that extend beyond typical market cycles.
Closing Thoughts
Alternative investments present a compelling opportunity for investors seeking new potential for their portfolios and returns. By understanding the nature of these investments (and being mindful of the associated risks), investors can effectively incorporate alternative investments into their strategy. As the investment landscape continues to evolve, the potential of alternative investments in achieving long-term financial goals becomes increasingly apparent.
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1 Morningstar. 2024. Crypto, REITs, Private Equity: Long-Term Investments or Short-Term
Trends? February 28. https://www.morningstar.com/personal-finance/crypto-reits-private-equity-long-term-investments-or-short-term-trends
Disclosure: Interactive Brokers
The analysis in this material is provided for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad-based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation by IBKR to buy, sell or hold such investments. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.
The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Interactive Brokers, its affiliates, or its employees.
Disclosure: Short Selling
Short selling is an advanced trading strategy involving potentially unlimited risks and must be done in a margin account.
Disclosure: Hedge Funds
Hedge Funds are highly speculative, and investors may lose their entire investment.
Disclosure: Digital Assets
Trading in digital assets, including cryptocurrencies, is especially risky and is only for individuals with a high risk tolerance and the financial ability to sustain losses. Eligibility to trade in digital asset products may vary based on jurisdiction.
Disclosure: Complex or Leveraged Exchange-Traded Products
Complex or Leveraged Exchange-Traded Products are complicated instruments that should only be used by sophisticated investors who fully understand the terms, investment strategy, and risks associated with the products. Learn more about the risks here: https://gdcdyn.interactivebrokers.com/Universal/servlet/Registration_v2.formSampleView?formdb=4155
Disclosure: Alternative Investments
Alternative investments can be highly illiquid, are speculative and may not be suitable for all investors. Investing in Alternative investments is only intended for experienced and sophisticated investors who have a high risk tolerance. Investors should carefully review and consider potential risks before investing. Significant risks may include but are not limited to the loss of all or a portion of an investment due to leverage; lack of liquidity; volatility of returns; restrictions on transferring of interests in a fund; lower diversification; complex tax structures; reduced regulation and higher fees.
