An alternative investment is an asset that does not fall into a conventional investment category such as stocks or bonds. The sector can be split into financial and tangible alternative investments as shown in the following table.
| Financial | Tangible |
|---|---|
| Cryptocurrency | Precious Metals |
| Financial Derivatives & Managed Futures | Art |
| Private Equity Firm | Wine |
| Distressed Securities | Antiques |
| Hedge Fund & Funds of Funds | Rare Coins |
| Exchange Funds | Stamps |
| Carbon Credits | Jewelry & Diamonds |
| Venture Capital | Real Estate |
| Film Production | Commodities |
| Private Placement Debt | Oil |
| Direct Investment in Start-ups & Private Companies | Forestry & Agricultural Land |
As the table demonstrates, the term has a relatively loose definition and has even been known to include collectible items such as baseball cards. Alternatives are non-conventional investments as opposed to the traditional conventional investment categories consisting of either stocks, bonds, or cash. In addition, although alternative investments are considered anything other than these assets, investment strategies other than a traditional long only approach such as event driven investment strategies or arbitrage strategies may also be considered alternatives.
Alternative Investment Background
Alternative investment performance can be contrasted with traditional investments. Since alternatives tend to perform independently to typical stock and bond investments, including them to a portfolio of investments will provide greater diversification. This helps reduce risk in terms of value fluctuations and can potentially enhance returns. Therefore, alternative investments are useful investment strategies for investors looking to diversify their portfolios from traditional funds.
Most financial alternative investment assets are held by institutional investors. This is in large part due to accessibility of making the investment such as supplying venture capital to a start-up or a Private Equity Firm arranging an LBO. Having specialist knowledge and resources to value assets such as distressed debt is also beyond the capabilities of many. The lack of regulation and high degree of risk makes these investment unsuitable for many investors. Accredited, high-net-worth individuals may also hold assets in these areas but may also be involved in the tangible and collectible areas of alternative investments such as art and antiques.
Investments in.... Alternative Investments
Perhaps one of the main reasons for the exclusivity of many alternative investments is the high minimum investment required. Many organized funds in this area set a minimum of $1m. The fee structures may also appear high to many investors accustomed to simpler structures such as mutual funds or Exchange Traded Funds (ETF‘s).
Liquidity is also a major issue. Investors will to find it significantly more difficult to sell a collectible item of jewelry or rare bottle of wine compared to 100 shares of Amazon (AMZN). A specialist auction may be required unless to investor is willing to accept a lower price from a dealer in order to sell immediately. As most alternative assets are fairly illiquid, especially when compared to conventional assets, investors must be prepared to make long term investments.
A further difficulty may arise in valuing alternative investments. Collectible assets are rare and the transactions involving them are even rarer. Art auctions are a prime example of this. Assigning a value or even a “guideline” price at an auction is extremely difficult. Many times these valuations have proved to be way off the mark. Liquidity and valuation difficulties also lead to less verifiable performance data. It is difficult to therefore to measure performance of asset classes over comparable periods. Thus, investment funds have great difficulty in conveying their benefits to potential investors.
Common Characteristics
Despite the range and scope of potential alternative investments, they still maintain a loose set of common characteristics such as:
- Lower correlation with traditional financial investments such as equities and fixed income (bonds)
- This may be extremely beneficial to potential investors because the low correlation provides opportunities for portfolio diversification.
- Difficulty in determining the current or fair market value of the asset
- Alternative investments are often inherently complicated when it comes to valuation. The valuation of an alternative investment may require specific knowledge, and some exotic investments, such as fine art, may show unpredictable demand patterns. In addition, they may be unique in their nature, which also complicates the valuation.
- Alternative investments are often illiquid relative to the more mainstream investment options
- Generally, alternative investments possess relatively low liquidity, especially compared to traditional investments. The low liquidity can be explained by the absence of centralized markets and the low demand for some of the assets relative to traditional investments (think about works of contemporary art). In addition, some of the investments come with restrictions regarding exiting from the investment.
- Transaction costs are often higher as a percentage of the asset value
- Alternative investments are frequently associated with high purchasing costs. Some alternative investments such as hedge funds require a minimum investment amount, as well as a fee.
- There is limited reliable historical price data
- The illiquid nature of the asset may make it difficult to generate any historical or trend analysis
- A large amount of specialist analysis involving industry professionals may be required for valuation
- The specific nature of the asset maybe require an art historian or philatelist focusing on a specific painter stamp issue or which could lead to greater subjectivity
