Alternative Investments for Beginners
Understanding the Role Alternative Assets May Play in a Diversified Portfolio
Although they have always held the fascination of investors, alternative investment seem to be gaining popularity in recent years as both individuals and institutions look for ways to change their volatility exposure and potentially generate surplus returns beyond holding stocks and bonds. From cryptocurrencies to mineral rights, structured settlements to timberland, tax lien certificates to cell tower leases, alternative investments can be a compelling choice for the right investor, under the right circumstances; particularly for those with specialty knowledge in a specific area or for high net worth families, which can often benefit more from certain tax offsets or entity structures than those with more modest household income.
In this introduction to alternative assets, we are going to address four important questions:
- What is an alternative investment or alternative asset?
- What are some examples of alternative investments or alternative assets?
- Why do investors seek out alternative investments or alternative assets?
- What are some of the major benefits and drawbacks of including alternative investments or alternative assets in a diversified portfolio?
My hope is that you will have a much better grasp on the concept as we examine each of these topics over the next few minutes; particularly in regards to some of the substantial risks that could cause you a lot of financial and emotional pain and suffering. (In investing, there's a lot to be said for focusing on what can go wrong. The good news usually takes care of itself.)
What Is an Alternative Investment or Alternative Asset?
To appreciate how alternative assets are defined, you need to understand two related concepts known as asset classes and asset allocation.
Put simply, an asset class is a type of asset that has a certain set of similar characteristics; e.g., how it generates a return, the risks involved in owning or holding it, its correlation with other asset classes or economic forces such as interest rates. Asset allocation refers to building a model or mapping out a general guideline as to the rough percentage of a portfolio an investor wants to have working in each asset class.
Usually, this asset allocation will be spelled out in a document called an investment policy statement. We discussed some of the issues that you might want to contemplate when faced with determining a proper asset class target in an article called Things to Consider When Balancing Your Asset Class Exposure.
Traditionally, there are a handful of what you might call "core" asset classes that a reasonable person might consider adding to his or her investment portfolio. That is, if you were administering a balanced trust fund or hiring an asset management company or registered investment advisor to put together and maintain a diversified portfolio for you or your heirs, you would the portfolio to contain one or more of the following:
- Cash and cash equivalents
Why does that matter? In its broadest sense, an alternative investment, or alternative asset, is any type of asset that does not fall into one of these categories. That is, an alternative investment is anything not made up of cash, stocks, or bonds.
What Are Some Examples of Alternative Investments or Alternative Assets?
While the list of alternative investments is extensive, some of the ones you might encounter in the real world include, but are not necessarily limited to, the following:
- Real estate and all of its many derivations including directly-owned property, real estate limited partnerships, real estate development corporations, and REITs
- Master limited partnerships, which can own and operate everything from oil pipelines to capital-intensive theme parks
- Tax lien certificates
- Stock or membership units in a privately held business
- Commodities, including precious metals such as gold, silver, platinum, and palladium, as well as crude oil, natural gas, ethanol, corn, soybeans, wheat, cocoa, coffee, sugar, frozen concentrated orange juice, oats, live cattle, copper, lead, zinc, tin, aluminum, nickel, and cobalt
- Managed futures
- Mineral rights
- Intellectual property such as copyrights, song rights, patents, and trademarks
- Privately underwritten mortgages
- Equipment leasing
- Structured settlements
- Art and collectibles
- Private equity
- Coins that have numismatic value
- Venture capital
- Peer-to-peer lending
- Hedge funds
- Tax credits
Why Do Investors Seek Out Alternative Investments or Alternative Assets?
There are several reasons an investor or a portfolio manager is likely to consider adding alternative investments to the balance sheet.
In some cases, a dollar of cash flow generated from an alternative investment might be subject to far more favorable tax treatment than a dollar generated from a more traditional investment; e.g., if an investor or client has significant tax-loss carryforwards or tax credits that can be applied to a particular type of activity or source of income.
In other cases, factors and conditions specific to that particular asset class at the time the investment is considered might make the asset class appear significantly cheaper, and thus more attractive for a long-term owner, than other types of investments available in the market; e.g., there was a period during the aftermath of the Great Recession when wealthy investors were buying deeply discounted condos in cities such as Miami, paying a fraction of what they thought the ultimate market value would be in the future.
Sometimes, the investor or his or her advisors have a deep knowledge or unique skill set in a specific area that can cause alternative investments to make sense. For example, if an experienced entrepreneur in the oil and gas industry had the resources and patience to take advantage of a major oil and/or gas glut, that unique knowledge and experience might pay off handsomely as it allows the investor to lower his or her risk in ways an inexperienced investor might not even consider, let alone know exist.
In other situations, a particular alternative investment or alternative asset class might emotionally and intellectually hold the attention of the investor more than other asset classes. For example, there are successful investors who are deeply drawn to venture capital because they enjoy the process of identifying, funding, and taking ownership in startups and relatively new enterprises; to see them grow and prosper, knowing they were part of it. There are some investors, particularly those who are older, who do not like owning stocks and bonds, preferring to underwrite their own mortgages on real estate properties they have acquired and renovated. It makes sense to them. They feel that they can better understand the potential gains and losses, especially when compared to the daily volatility that is part and parcel of owning publicly-traded common stock. There are some investors who acquire catalogs of music rights, either at auction, in negotiated transactions, or through bankruptcy court proceedings because they understand how to administer and license those rights to interested parties. Arguably among the most famous alternative investors are so-called "Gold Bugs" who hoard gold bullion in coin and bar form. For many who fall into this camp, gold becomes almost an obsession that often doesn't seem entirely rational to those who don't feel the same compulsion to amass the legendary metal.
What Are Some of the Major Benefits and Drawbacks of Including Alternative Investments in a Diversified Portfolio?
We've already discussed several of the potential benefits of alternative investments — tax-advantaged or sheltered cash flows under certain circumstances, less efficient markets that can lead to exploitable opportunities, intellectual and emotional satisfaction when dealing with an asset the investors likes, understands, and feels he or she has a competitive or strategic leg up on the competition — so it's probably best to focus on the negatives, of which there are many. The list of such negatives would be exhaustive so I'd prefer to cover two that I believe are particularly dangerous.
Firstly, alternative investments can be complicated and involve significant hidden risks. Often, when investing in things such as pooled structures, there can be a lack of transparency that makes it impossible to truly understand the risks you are taking. One real-world illustration: in the official Government report on the Financial Crisis of 2007-2009, the commission found that certain funds sponsored by investment banks had engaged in what is often called "window dressing" by selling risky assets and/or reducing debt prior to the end of a reporting period to make the funds look safer to the owners. These owners were given a false sense of comfort about what they owned and the risks to which their capital were exposed. It isn't unheard of for alternative investments to be wiped out in a total, complete loss for investors. A healthy fear is wise when treading into many of the areas listed earlier in this article. Your ability to say "no" — to walk away from an investment you don't fully understand — can lower the chances of being forced to watch your wealth get blown up in front of your eyes. Do not let the fear of missing out on something exciting cause you to do something dumb.
Secondly, alternative investments can create nightmare, and sometimes outright catastrophic, tax consequences. For example, imagine that you have a self-directed retirement plan. Perhaps it's a SEP-IRA. You decide you want to own an oil pipeline master limited partnership, or MLP, through your SEP. While it depends upon a number of factors, you have created a situation in which your SEP-IRA might now be required to file its own tax return and, worse, pay taxes! This is going to be a lot of added complexity and cost which, under certain conditions, might be worth it, but one that could be an unpleasant surprise if you didn't know it was a possibility. Another illustration: you consider investing in a private partnership. The partnership doesn't have a mandatory tax distribution clause despite being structured for pass-through taxation. You could end up with a huge tax bill that you have to pay out of pocket even if the partnership doesn't distribute any cash to you during that tax year! That might be fine if you have a lot of spare liquidity sitting around and you feel the investment still makes sense but it could create real hardship if you had to sell other assets or borrow money to pay your bill to the IRS.
Disclaimer: The content on this site is provided for information and discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.