Pros and Cons of Alternative Investments

October 15, 2021

Over the last few years, alternative investments have grown in popularity, in part because they offered outsized returns compared to the stock market. In 2020 alone, in fact, global alternative investment funds raised more than $857 billion.

These investments were once reserved for institutional and high net worth investors. However, retail investors are following in the footsteps of the big money and using similar strategies to grow their wealth and to plan for the future.

Alternative investment classes can bring a wide range of benefits to your investment portfolio, but they aren’t without their downsides. Here is a look at the good and potentially bad about alternatives.

What are alternative investments?

An alternative investment is a financial asset that is bought and sold outside of the conventional stock, bond, and commodity markets. Instead, these assets include hedge funds, private equity, managed futures, art and antiques, and derivatives contracts. Real estate is also considered to be an alternative investment.

Many of these investments have fewer SEC regulations. They’re also more illiquid. Today, alternative investments are more readily available to retail investors via mutual funds, EFTs, and alt funds.

The upside of alternative investments

There’s a reason why alternative investments are becoming increasingly popular. Here are some of the key benefits.

Not correlated to the stock market: At times, the stock market can be extremely volatile. There’s nothing worse than watching your portfolio dip into the red for days, if not weeks at a time. One of the benefits of alternative investments is that they don’t correlate to the stock market. This means that they add diversification to your investment portfolio while also minimizing volatility.

Potential for increased returns: As with any investment, there’s no guaranteed rate of return for alternatives. However, there is a greater potential for higher returns, especially when compared to traditional options. According to historical data cited in a study titled The Rate of Return on Everything, 1870-2015, residential real estate and equities provided the best returns. This is proof that alternative investments have reigned king for more than 145 years.

Put your expertise to good use: If you’re an expert in art or real estate, you may have a huge edge when it comes to alternative investments. For example, if you’re an experienced flipper, you have a great advantage over novices and companies that are more concerned with volume over quantity.

Because of your expertise, you can find opportunities that others may overlook, analyze deals faster, and then execute deals that best benefit you. By having a team of ready-to-go contractors who can rehab and renovate, you’re able to avoid time and money sinks. All of these edges work to improve your returns.

The risks of alternative investments

As with anything in life, especially in the financial and investment realms, with the good comes some bad. Here are some risks to be aware of when adding alternative investments to your portfolio.

Illiquidity: Most alternative investments are private versus public, which makes them mostly illiquid by nature. Not only is it harder to exit these investments, your money may be tied up for an extended period of time, since you can’t just sell or trade them in like a traditional stock.

Real estate is a prime example. Let’s say you spend $200k on a home and rent it out for years. But after some time, you’re tired of being a landlord. Depending on the housing market, you may be stuck waiting for weeks, if not months, to get the home listed and sold.

Lack of regulation: Unlike traditional investments, alternative investments aren’t regulated. This means that they aren’t subject to traditional reporting requirements either. Additionally, the underlying assets of these investments are often very difficult to value. In turn, there are challenges with price transparency and pricing in general.

Because alternative investments aren’t well-regulated, there’s also an increased risk of fraudulent and fake investments. When you buy shares of stock, you can buy with total confidence because you know the shares are real. But when investing in art, collectible trading cards, or anything that can be faked, there’s a much higher risk.

Complexity: Alternative investments can be extremely complex and often require a higher level of due diligence. If you’re considering alternative investments, make sure that you thoroughly research the potential tax implications.

For instance, when you invest in property, you’ll become a limited partner. Each year, you’ll receive a Form K-1 for every single partnership that you have. If you invest in property in various locations, you’ll have to file a tax return in each of those states.

Potential for higher fees: Depending on the type of alternative investment, you may face higher fees than expected. Unlike conventional investments like mutual funds, alternative investments fees aren’t always as transparent, nor are they regulated.

Fees vary based on the type of investment. You’ll pay different fees when investing in art, wine, real estate, or ex-US currencies. Before getting too deep into it, be sure that you understand the fees and how they’re charged. Some platforms charge maintenance fees while others take a percentage of each transaction.

Although alternative investments were once reserved for institutional and high net worth investors, these investments continue to become increasingly popular for everyday retail investors. And for good reason.

Proponents maintain that because the assets aren’t connected to the stock market, there’s a greater potential for higher returns while also offering diversification. But, before leaping headfirst into the alternative sector, it’s best to do your research and learn everything you can about the options, markets and trends to inform your decisions. This way you can confidently invest your money while minimizing the inherent risk that comes with alternative investments.

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