What Are the Risks of Alternative Investments?

October 13, 2022

Alternative investments are often more complex than traditional investment products. That complexity can be associated with higher risks. Because alternative investments have a low correlation to traditional markets, the risks accompanying them are also different.

While alternatives can provide higher returns and lower volatility due to portfolio diversification, it is important for investors to understand the risks of investing.

What are Alternative Investments?

Alternative investments are financial assets that don’t fall under conventional asset classes such as stocks, bonds, and cash. This umbrella term is quite broad, encompassing private equity, venture capital, hedge funds, managed futures, commodities, real estate and collectibles like art and antiques.

Risks of Alternative Investments

Alternative investments cover a wide array of investment products, all of which will carry slightly different types and levels of risk, but there are some commonalities.

Below are some of the most common risks associated with all types of alternative investments.

Low Liquidity

Because many alternative investments are not publicly traded, it may be difficult to buy or sell these investments. Many hedge funds and private equity funds tend to have lockup periods that commit investors to a defined investment period during which redemptions can be impossible.

What’s more, alternatives such as collectibles are long-term investments, meaning their value appreciates slowly over time and is not dictated by market movement. This means most collectors have to hold these investments longer in order to see a return.

Some alternative investments do trade on public markets or private secondary markets. This can help to alleviate some of the pain of illiquid investments, but they still will be less liquid than stocks.

Difficulty in Valuation

Traditional investments like equities and fixed income have an official market price, while most alternative assets do not. Traders in the equity market have multiple benchmarks by which to value their portfolios. These centralized and regulated benchmarks do not exist for most types of alternative investments.

In the absence of a market price, it can be challenging to determine the value of alternative investments. Valuations, especially for hard assets such as Contemporary Art or classic cars, may vary widely depending on the appraiser. These valuations are more vulnerable to subjectivity.

High Minimum Investments

Alternatives have historically not been structured with the average individual investor in mind, so minimum investment requirements can often be very high. In the past, alternative investments had been restricted to accredited investors due to the risks associated, allowing them to create high initial minimum investments and charge higher fees.

This is becoming less and less the case as more alternative investment platforms pop up and the rise of fractionalized shares continues. Still, compared to the near nonexistent minimum for investing in mutual funds or ETFs, the minimum can be prohibitory.

For example, to invest in Contemporary Art without fractionalization, the minimum investment would be multiple millions of dollars for a blue-chip piece of art. However, with Masterworks, investors are able to purchase $20 shares of multi-million dollar artworks for a minimum investment of only $5,000.

More Complexity

Alternative investments, by nature of not being correlated with traditional markets, tend to have more complex valuation and return metrics. These investment instruments are often complicated and may require a higher level of due diligence before investing.

Hedge funds, for example, may invest in a wide variety of assets and can utilize investment strategies such as short selling which heightens risk. The complex nature of alternative investment strategies is partly why alternatives historically were only available to institutional investors.

To best understand the complexity of these investment opportunities, investors often work with a financial advisor. Advisors can assist in making investment decisions, general asset allocation, and helping investors reach their goals.

Lower Transparency & Regulation

Not all alternative assets are registered with the US Securities and Exchange Commission (SEC) and therefore are not regulated the same as traditional asset classes.

Alternatives do fall under the purview of the Dodd-Frank Act and therefore, their practices may be reviewed by the SEC, but there is little to no registration requirement for many alternatives purchased outright.

Registration with the SEC provides an array of information for investors regarding the asset including deal sheets and information regarding historical performance. This information is likely unavailable for potential investors if an asset is not registered.

However, alternative assets that are purchased through alternative investment platforms or through indices are more regulated than purchasing alts outright. These platforms offer a higher level of transparency, information, and safety for investors.

For alternative investment funds, risk factors include management risk. The performance of hedge funds, REITs, funds of funds and more are often linked specifically to the performance of the hedge fund manager.

Overcoming the Risks

Alternative investments have gained a lot of traction and popularity since the 2008 financial crash. In today’s market conditions — interest rates rising, high inflation and stock market volatility — some investors may be looking beyond stocks and bonds for other options of where to store their money.

To understand why investors would take on these risks to invest in alternatives, it’s important to understand what potential upsides these investments provide.

Because the performance of alternatives has a low correlation with traditional financial markets, they typically help provide diversification across different markets, investment strategies, investment managers and styles. Portfolio diversification can help to reduce overall volatility associated with market risk.

In addition to portfolio management benefits, alternative assets provide the potential for increased returns. Like any investment, the rate of return for alternatives is never guaranteed. However, according to an NBER study that looked at past performance across 16 advanced economies over a period of 145 years (1870-2015), alternative assets including real estate investments and collectibles provided the highest and most consistent rate of return when the asset was sold.

The Bottom Line

Alternative investments have low correlation with the stock and bond market, offering diversification and potentially higher returns when compared to equity investments. On the other hand, most alternatives are relatively illiquid and complex, meaning they are difficult to sell quickly and often have higher risks than traditional investments.

Adding alternatives to your investment portfolio is easier now than it has ever been in the past. High-yield alternative investments have historically been available only to investors with a significant net worth. Now, with the rise of online investment platforms and fractionalization, most average investors can now access private markets.

Start Investing in Alternatives with Masterworks

Masterworks is the first company to open the art market to retail investors by offering fractional shares of blue-chip artworks. Investors can purchase $20 shares of multi-million dollar works of art from some of the world’s most sought-after artists such as Jean-Michele Basquiat, Claude Monet, and Banksy

If higher fees and higher barriers to entry are deterring you from investing in alternative assets, Masterworks can be a great entry point to the world of art investing. Masterworks’ industry-leading research and acquisition teams use proprietary data and market expertise to curate a collection of iconic works of Contemporary Art. 

See important Regulation A disclosures at masterworks.com/cd 

Masterworks is a fintech company democratizing the art market. Our investors are able to fractionally invest in $1mn+ works of art by some of the world's most famous and sought-after artists.