After nearly an 11-year bull market and fixed-income returns historically low, interest in alternative investments is starting to grow.
But they're not for everyone. Access is limited to high-net-worth individuals and entities who are allowed to invest in securities not always registered with financial regulators. These investors usually fall under two groups: accredited investors and qualified purchasers, says Miguel Sosa, portfolio strategist at Artivest, an investment platform for alternative assets.
Accredited investors must have an income exceeding $200,000 individually,or $300,000 for joint income, for the last two years, with the expectation that will continue, or have a net worth exceeding $1 million, individually or jointly. Qualified investors have an investment portfolio of $5 million or more, individually or jointly, he says.
Those requirements may be changing to allow more investors to access these markets as the Securities and Exchange Commission has proposed rules to expand the accredited investor definition, says William Kelly, CEO at CAIA Association.
What are alternative investments?
People who want exposure to alternative assets seek investments outside of the traditional markets of stocks, fixed-income or cash. The goal is to create portfolio diversification, says Keith Black, managing director of curriculum and exams for CAIA Association.
Investing in alternative assets often requires buyers to lock up their money for five, maybe 10 years, says Joe McLean, managing partner of multifamily office Intersect Capital. During that time investors may not see any money distributed. Liquidity is also an issue as fund managers can't easily buy or sell holdings like managers in traditional markets, so investors can't easily tap those assets when they want.
Many types of alternative asset classes aren't correlated with stocks and are expected to perform best when equity returns are flat or down, Black says.
Here are a few common alternative investments:
-- Private equity.
-- Venture capital.
-- Hedge funds.
-- Real estate.
Private equity invests in nonpublicly traded companies. Investors' money can be unavailable for as long as 10 years as they wait for the private equity fund to sell the holdings in an initial public offering, or sell to a strategic buyer or in a merger, Black says.
Transparency is an issue, Sosa says, as buyers often commit to investing in a blind pool.
"Nobody really knows what the investments are going to be until the manager actually finds the compelling opportunities," he says.
Sosa says venture capital is a sub-category of private equity. It invests in early-stage companies that have the potential for outsized growth, or are looking to expand rapidly in a new or innovative space. There's a high chance for failure, he says, since many of these companies may not have revenues or profits yet, but also high reward if the firms succeed.
Private equity and venture capital may require investors to make capital calls, McLean says.
An investor may commit $200,000 to a fund, but the managers take money in $50,000 tranches over two years. If investors don't have the earmarked funds available when the manager needs it, they can pay enormous penalties.
"You have to be prepared to have that built into your financial plan as if you've already invested the entire amount," he says.
Many strategies around hedge funds attempt to offer some sort of return and to be a buffer when traditional assets fall, Sosa says.
One common strategy is equity long-short. Managers will invest in a company which has the potential to appreciate, but they may also sell short, or bet against the company and would profit if the value goes down. Hedge funds may use absolute return strategies, also known as "all-weather strategies," investing in many different asset classes and strategies to generate returns no matter what traditional markets are doing.
Real estate is considered an alternative asset when people buy investment property such as office buildings or residential apartments, says Sal Bruno, managing director and chief investment officer for IndexIQ, an exchange-traded fund provider with alternative asset ETFs. Investors who may not want to be landlords can use a broker to buy into private real estate investment trusts, or REITs. Publicly-traded REITs are listed on stock exchanges.
"The public real estate investment trusts have some characteristics of real estate, but oftentimes are considered to be very equity-oriented," Bruno says; that's because they are traded on exchanges.
Commodities are mostly natural resource investments, such as crude oil, corn and coffee. Being real assets, they are often considered an inflation hedge.
Commodity trades are implemented in the futures market, Bruno says, and have set times during the year when contracts mature.
Investors need to sell the contract ahead of maturity and buy a new one to hold the position. Sometimes the new contract is more expensive than the old contract, which can be a drag on performance.
"These roll issues are well documented," he says.
Fees can be high, McLean says. Most alternative investments have an upfront fee of 2% and when the fund distributes the money, managers take 20% of the gains.
"If you're going to be paying those excessive fees, which is what I would consider them, make sure that there's a track record that shows the fund is outperforming the fees," he says.
To judge performance, buyers can't use traditional benchmarks like the S&P 500, Kelly says, but need to compare their holdings with the average return of funds in that strategy, so comparing hedge funds to other hedge funds.
McLean says most people access alternative assets through an institution or their financial advisor, but newer digital platforms are starting to offer ways to buy directly. He says for new buyers it's still best to invest with a professional who understands the asset class, its benefits and challenges.
"Liquid alts" are growing in popularity, say Kelly and Black, such as mutual funds and ETFs that offer exposure to alternative investments. These regulated securities are available to anyone. "They have daily liquidity, they're going to have a prospectus and a holdings report," Black says.
Investing in these liquid alt funds isn't the same as direct alternative asset ownership because of the restrictions placed on regulated securities, Black says.
There are limits on leverage and diversification because they can't invest in assets with illiquidity. They can be an introduction to the space, but the expense ratios can be higher than traditional market vehicles without being much more diversified.
"If you look underneath the hood, you may find that you're paying a reasonably high fee for something that doesn't look much different than say an S&P 500 index fund," Kelly says.
Debbie Carlson has more than 20 years experience as a journalist and has had bylines in Barron's, The Wall Street Journal, the Chicago Tribune, The Guardian, and other publications. Follow her on Twitter at @debbiecarlson1.