The Different Types of Alternative Investments: Diversifying Beyond Stocks and Bonds

The Different Types of Alternative Investments: Diversifying Beyond Stocks and Bonds

By
Albert Pinedo
|
June 26, 2024

Alternative investments have emerged as a crucial component of modern investment portfolios, offering investors a means to diversify beyond the traditional realms of stocks and bonds. These unique asset classes provide access to a wide range of opportunities, from private equity and real estate to hedge funds and commodities. By incorporating alternative investments, investors can potentially enhance their risk-adjusted returns, hedge against market volatility, and tap into growth prospects that may be inaccessible through conventional investment channels.
In this comprehensive guide, we will explore the various types of alternative investments, delving into their characteristics, potential benefits, and considerations for investors. Whether you're a seasoned investor or just starting to explore the world of alternatives, this article will equip you with the knowledge to make informed decisions and strategically diversify your portfolio.

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1. Private Equity

Private equity refers to investments in privately held companies, rather than publicly traded ones. This asset class encompasses a diverse range of strategies, including venture capital, growth capital, and buyouts. 123

Venture Capital

Venture capital (VC) is a type of private equity that focuses on investing in early-stage, high-growth potential companies. VC firms provide capital, strategic guidance, and industry expertise to help these startups and emerging businesses scale and succeed. The potential for outsized returns is a key draw for venture capital investors, as successful VC investments can generate significant profits. However, the risk profile is also higher, as many or most VC-backed companies may fail or struggle to achieve their growth targets. 12

Growth Capital

Growth capital investments target more established private companies that are seeking to expand their operations, enter new markets, or fund strategic initiatives. These investments are typically made in companies that have already demonstrated a track record of success and are poised for further growth. The goal is to provide the necessary capital and support to help these businesses reach the next level of their development. Growth capital investments often have a lower risk profile compared to venture capital, as the underlying companies are more mature and have a proven business model. 12

Buyouts

Buyout transactions involve the acquisition of a controlling stake in a private company, either through a leveraged buyout (LBO) or a management buyout (MBO). In an LBO, the acquiring firm uses a significant amount of debt financing to fund the purchase, while an MBO is initiated by the company's management team. Buyout strategies aim to generate returns through operational improvements, financial engineering, and eventual sale or public offering of the acquired company. Buyout investments are typically made in more established, mature businesses with stable cash flows. 12

The appeal of private equity lies in its potential for higher returns compared to traditional asset classes, as well as the opportunity to gain exposure to high-growth sectors and emerging industries. However, private equity investments are generally illiquid, with long investment horizons and higher fees compared to publicly traded securities. 123 Additionally, the high level of debt used in leveraged buyouts (LBOs) can significantly increase the risk of financial distress and potential total loss of investment if the acquired company fails to meet performance expectations and cannot service its debt obligations 


2. Private Debt

Private debt refers to loans and other debt instruments that are not traded on public exchanges. This asset class includes a range of strategies, such as direct lending, mezzanine financing, and distressed debt. 123

Direct Lending

Direct lending involves providing loans directly to private companies, often small and medium-sized enterprises (SMEs) or middle-market firms. These loans are typically secured by the borrower's assets and can provide a steady stream of interest income for investors. Direct lending strategies aim to generate returns through the interest earned on the loans, as well as potential capital appreciation if the underlying companies perform well. 12

Mezzanine Financing

Mezzanine financing is a hybrid form of debt and equity financing, typically used to fund the growth or expansion of private companies. Mezzanine debt is subordinate to senior debt but senior to common equity, offering a higher return potential than traditional debt but with lower risk than pure equity investments. Mezzanine financing can provide companies with the necessary capital to execute their strategic plans, while offering investors a balance of income and potential capital appreciation. 12


Distressed Debt

Distressed debt investments involve the purchase of debt securities from companies that are experiencing financial difficulties or are in the process of restructuring. Investors in this space aim to capitalize on the discounted prices of these debt instruments, with the goal of generating returns through the eventual recovery or restructuring of the underlying company. Distressed debt investing requires a deep understanding of the company's financial situation, as well as the ability to navigate complex legal and regulatory environments. 12

Private debt investments can offer investors a steady stream of income, diversification benefits, and potentially higher returns compared to traditional fixed-income assets. However, these investments also carry higher risks, including credit risk, illiquidity, and the potential for default. Thorough due diligence and risk management are crucial when investing in private debt. 123

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3. Hedge Funds

Hedge funds are actively managed investment vehicles that employ a wide range of strategies to generate returns, often with the goal of achieving positive returns regardless of market conditions. These strategies can include long-short equity, global macro, event-driven, and arbitrage, among others. 123


Hedge funds are typically structured as limited partnerships or limited liability companies, with the fund manager serving as the general partner and the investors as limited partners. The fund manager is responsible for implementing the investment strategy and making investment decisions on behalf of the fund. 12

The key characteristics of hedge funds include:

  • Diverse investment strategies: Hedge funds can employ a variety of strategies, including long-short equity, global macro, event-driven, and arbitrage, among others.
  • Use of leverage: Hedge funds often use leverage to amplify their investment returns, which can also increase the risk profile of the fund.
  • Illiquidity: Hedge fund investments are generally less liquid than traditional investments, with investors typically subject to lock-up periods and redemption restrictions.
  • High fees: Hedge funds typically charge higher fees than traditional investment vehicles, including a management fee and a performance-based incentive fee. 123

The potential benefits of investing in hedge funds include diversification, the ability to generate positive returns in various market environments, and access to specialized investment strategies. However, hedge funds also carry higher risks, including leverage risk, operational risk, and the potential for higher volatility. Careful due diligence and a thorough understanding of the fund's investment strategy and risk profile are essential when considering hedge fund investments. 123

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4. Real Estate

Real estate is a tangible asset class that has long been a staple of alternative investment portfolios. Real estate investments can take various forms, including direct ownership of properties, real estate investment trusts (REITs), and real estate-focused funds. 1234
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Direct Real Estate Ownership

Direct real estate ownership involves the purchase and management of physical properties, such as residential, commercial, or industrial real estate. Investors in this space can generate returns through rental income, property appreciation, and potential tax benefits. Direct real estate ownership requires significant capital, hands-on management, and expertise in property selection, acquisition, and operation. 124

Real Estate Investment Trusts (REITs)

Real Estate Investment Trusts (REITs) are companies that own, operate, or finance income-producing real estate. REITs are publicly traded, providing investors with a more liquid and diversified exposure to the real estate market. REITs are required to distribute at least 90% of their taxable income to shareholders, often resulting in attractive dividend yields. Investing in REITs can offer investors the benefits of real estate exposure without the responsibilities of direct property ownership. 124

Real Estate Funds

Real estate funds are investment vehicles that pool capital from multiple investors to invest in a diversified portfolio of real estate assets. These funds can focus on specific property types, geographic regions, or investment strategies, such as value-add, opportunistic, or distressed real estate. Real estate funds provide investors with professional management, diversification, and access to institutional-quality properties that may be difficult for individual investors to acquire. 124

The potential benefits of real estate investments include stable income, potential for capital appreciation, and diversification from traditional asset classes. However, real estate investments also carry risks, such as property-specific risks, market cycles, and regulatory changes. Careful analysis of the property, market conditions, and investment strategy is crucial when considering real estate as an alternative investment. 1234


5. Commodities

Commodities are raw materials or agricultural products that are traded on organized exchanges, such as metals, energy, and agricultural goods. Investors can gain exposure to commodities through various means, including futures contracts, exchange-traded funds (ETFs), and physical ownership of the underlying assets. 1234

Futures Contracts

Commodity futures contracts are agreements to buy or sell a specific quantity of a commodity at a predetermined price and future date. Investors can use commodity futures to speculate on price movements or to hedge against price fluctuations in their underlying business operations. Futures trading can provide leveraged exposure to commodity markets, but it also carries significant risks, such as volatility and the potential for losses. 124

Commodity ETFs

Commodity exchange-traded funds (ETFs) are investment vehicles that track the performance of a specific commodity or a basket of commodities. These ETFs provide investors with a more liquid and diversified way to gain exposure to the commodity markets, without the complexities and risks associated with direct futures trading. Commodity ETFs can be useful for portfolio diversification and as a hedge against inflation. 124

Physical Commodity Ownership

Some investors choose to hold physical commodities, such as gold, silver, or other precious metals, as part of their alternative investment portfolio. Physical commodity ownership can provide a tangible asset that may serve as a hedge against inflation and market volatility. However, this approach also comes with storage, security, and liquidity considerations. 124

Investing in commodities can offer diversification benefits, as commodity prices often exhibit low correlation with traditional asset classes like stocks and bonds. Commodities can also serve as a hedge against inflation, as their prices tend to rise with increasing prices for goods and services. However, commodity investments can be volatile and subject to significant price swings, requiring careful risk management and diversification within the portfolio. 1234


6. Collectibles

Collectibles are unique, tangible assets that are acquired for their rarity, historical significance, or aesthetic value, rather than their investment potential. Examples of collectible alternative investments include art, wine, classic cars, fine jewelry, and rare coins or stamps. 145

The appeal of collectibles as alternative investments lies in their potential for capital appreciation, as well as the personal enjoyment and satisfaction that comes with owning and curating a collection. Collectibles can also serve as a hedge against inflation, as their value may increase over time. 145

However, investing in collectibles also carries significant risks, including the potential for fraud, high transaction costs, and the subjective nature of valuation. Collectible markets can be opaque and illiquid, making it challenging for investors to buy and sell these assets at fair market prices. Thorough research, expert advice, and a deep understanding of the specific collectible market are essential when considering investments in this alternative asset class. 145


7. Cryptocurrency and Digital Assets

The rise of blockchain technology has given birth to a new class of alternative investments: cryptocurrency and digital assets. Cryptocurrencies, such as Bitcoin and Ethereum, are digital currencies that use cryptography to secure transactions and control the creation of new units. Digital assets, on the other hand, encompass a broader range of blockchain-based assets, including non-fungible tokens (NFTs), decentralized finance (DeFi) protocols, and other blockchain-based applications. 345

Investing in cryptocurrencies and digital assets can offer investors exposure to emerging technologies and the potential for significant capital appreciation. However, these investments also carry high volatility, regulatory uncertainty, and the risk of hacking or theft. Investors in this space must have a strong understanding of the underlying technology, the specific digital assets, and the overall ecosystem. 345

It's important to note that the regulatory landscape for cryptocurrencies and digital assets is still evolving, and investors should exercise caution and conduct thorough due diligence before investing in this alternative asset class. 345


Incorporating Alternative Investments into Your Portfolio

As you've seen, the world of alternative investments is vast and diverse, offering a wide range of opportunities for investors seeking to diversify their portfolios. When considering the inclusion of alternative investments, it's crucial to align your investment strategy with your financial goals, risk tolerance, and overall portfolio composition. 1234

Here are some key considerations when incorporating alternative investments into your portfolio:

  1. Diversification: Alternative investments can provide valuable diversification benefits, as they often exhibit low correlation with traditional asset classes like stocks and bonds. This can help reduce the overall volatility of your portfolio and improve risk-adjusted returns.
  2. Risk Tolerance: Alternative investments generally carry higher risks compared to traditional investments, with the potential for higher returns but also greater volatility. Carefully assess your risk appetite and ensure that the alternative investments you choose are aligned with your risk tolerance.
  3. Investment Horizon: Many alternative investments have longer investment horizons and lower liquidity compared to traditional assets. Ensure that your allocation to alternatives aligns with your investment time frame and liquidity needs.
  4. Fees and Expenses: Alternative investments often come with higher fees and expenses, including management fees, performance fees, and transaction costs. Factor these costs into your investment analysis and ensure that the potential returns justify the higher fees.
  5. Due Diligence: Thoroughly research and understand the specific alternative investment, its underlying assets, management team, and investment strategy. Seek the guidance of financial professionals and conduct comprehensive due diligence before making any investment decisions.
  6. Portfolio Allocation: Determine the appropriate allocation to alternative investments within your overall portfolio, taking into account your investment objectives, risk tolerance, and the diversification benefits they can provide.

By carefully incorporating alternative investments into your portfolio, you can potentially enhance your risk-adjusted returns, hedge against market volatility, and gain exposure to unique growth opportunities. However, it's essential to approach alternative investments with a well-informed and disciplined approach, ensuring that they align with your long-term financial goals and risk profile.

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Conclusion

The world of alternative investments offers a diverse array of opportunities for investors seeking to diversify their portfolios and potentially enhance their risk-adjusted returns. From private equity and hedge funds to real estate and commodities, the alternative investment landscape provides access to a wide range of asset classes that can complement traditional investments.

As you navigate the world of alternatives, it's crucial to understand the unique characteristics, risks, and potential benefits of each investment type. Thorough research, expert guidance, and a well-diversified approach are essential to successfully incorporating alternative investments into your overall investment strategy.

By embracing the power of alternative investments, you can unlock new avenues for growth, diversification, and risk management, ultimately positioning your portfolio for long-term success in an ever-evolving financial landscape.

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Albert Pinedo is an investment adviser representative with Savvy Advisors, Inc. (“Savvy Advisors”). Savvy Advisors is an SEC registered investment advisor. The views and opinions expressed herein are those of the speakers and authors and do not necessarily reflect the views or positions of Savvy Advisors. Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy.

Material prepared herein has been created for informational purposes only and should not be considered investment advice or a recommendation.  Information was obtained from sources believed to be reliable but was not verified for accuracy.  It is important to note that federal tax laws under the Internal Revenue Code (IRC) of the United States are subject to change, therefore it is the responsibility of taxpayers to verify their taxation obligations. 

Savvy Wealth Inc. is a technology company.  Savvy Advisors, Inc. is an SEC registered investment advisor. For purposes of this article, Savvy Wealth and Savvy Advisors together are referred to as “Savvy”.  All advisory services are offered through Savvy Advisors, while technology is offered through Savvy Wealth.  The views and opinions expressed herein are those of the speakers and authors and do not necessarily reflect the views or positions of Savvy Advisors.

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