Alternative investments frequently surface as options for investors who are looking for ways to change their volatility exposure and potentially generate additional returns beyond holding stocks and bonds. For the right investor, alternative investments can be a compelling choice for a diversified portfolio.
- Alternative investments consist of a wide range of assets that are outside of the "core" asset classes of cash (and equivalents), stocks, and bonds.
- Investors use alternative investments to diversify their portfolios, or to capitalize on timely market conditions, special interests, or unique bases of knowledge.
- Taxation of alternative investments can vary, depending on the specific asset, and buyers should be wary of hidden costs, fees, or legal hurdles.
What Is an Alternative Investment?
To appreciate how alternative assets are defined, you need to understand two related concepts: "asset classes" and "asset allocation."
An asset class is a type of asset that has a certain set of characteristics. There are a handful of what can be considered "core" asset classes that someone might consider adding to their investment portfolio. They include:
- Cash and cash equivalents
In its broadest sense, an alternative investment, or alternative asset, is any type of asset that does not fall into one of these three categories. The way you divide your investments among the different kinds of assets is asset allocation.
Examples of Alternative Investments
Alternative investments you might encounter in the real world include:
- Real estate, including directly owned property, real estate limited partnerships, real estate development corporations, and real estate investment trusts (REITs)
- Master limited partnerships, which can own and operate everything from oil pipelines to 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, or sugar
- Mineral rights
- Intellectual property, such as copyrights, 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
Pros and Cons of Alternative Investments
Before making alternative investments, it's wise to be aware of their potential benefits and drawbacks.
Possibility of tax-advantaged or sheltered cash flows
Less-efficient markets that can lead to opportunities
Intellectual and emotional satisfaction
Possibility of negative tax consequences
Lack of transparency, resulting in significant hidden risks
More complicated investments
Why Investors Seek Out Alternative Investments
There are several reasons an investor or a portfolio manager is likely to consider adding alternative investments to a balance sheet.
In some cases, money generated from an alternative investment might be subject to far more favorable tax treatment than that from a more traditional investment. For example, 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 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. For example, there was a period during the aftermath of the Great Recession when wealthy investors were buying deeply discounted condos in cities such as Miami and paying a fraction of what they thought the ultimate market value would be in the future.
Unique Skills or Knowledge
Sometimes, the investor or their advisors have deep knowledge—or a unique skill set in a specific area—that can cause alternative investments to make sense to them. For example, if an experienced entrepreneur in the oil and gas industry had the resources and patience to take advantage of a major oil or gas glut, that unique knowledge and experience might pay off handsomely.
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.
There are some investors 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 volatility of owning a publicly traded common stock.
There are some investors who acquire catalogs of music copyrights, either at auction, in negotiated transactions, or through bankruptcy court proceedings, because they understand how to administer and license those rights to interested parties.
Then there are the so-called "gold bugs," who are bullish on gold and collect it in coin and bar form.
Drawbacks of Alternative Investments
Alternative investments can be complicated and involve significant hidden risks.
Often, when investing in things such as pooled structures or commingled funds, there can be a lack of transparency that makes it impossible to truly understand the risks you're taking.
One real-world illustration: In the official U.S. government report on the financial crisis of 2007 to 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 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 was exposed. It's possible for alternative investments to be wiped out in a total loss for investors.
Healthy fear is wise when exploring unfamiliar investments. Your willingness to walk away from an investment you don't fully understand can lower your risks.
Alternative investments also can sometimes create negative tax consequences. For example, imagine that you have a self-directed retirement plan, such as a SEP-IRA. You decide you want to own an oil pipeline master limited partnership (MLP) through your SEP-IRA. While it depends upon a number of factors, you could create a situation in which your SEP-IRA might become required to file its own tax return and pay taxes. That could add a lot of complexity and cost, which might (or might not) be worth it.
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 liquid assets sitting around, and you feel that the investment still makes sense, but it could create a real hardship if you had to sell other assets or borrow money to pay your bill to the IRS.