Cryptocurrencies Are the New Alternative Investment
After the financial crisis of 2008, many financial firms and their clients recognized the importance of asset allocation and the need to diversify client portfolios. This led to portfolio managers increasingly adding alternative investments to their client asset allocation models.
A 2015 survey showed that advisors had 73% of their clients in alternative investments and that 70% of advisors planned to maintain their current alternative investment allocations for clients, although half of them felt that alternative investments had underperformed since 2008. Most advisors were recommending a range of 6% to 15% of a client's portfolio to be held in alternative investments. Many others (18% of advisors) were recommending 16% to 25% of their clients' portfolios in alternatives.
The latest alternative investment on the scene is cryptocurrency, and U.S. investors can get into this alternative investment almost as easily as buying up shares in a cryptocurrency exchange-traded fund (ETF) or some other proxy instrument.
Defining Alternative Investments
For those who are not familiar with them, alternative investments are defined as "non-correlated assets," meaning that their performance doesn't follow that of more traditional asset classes such as stocks and bonds. Because these assets move in the opposite direction of traditional investments, they may provide an effective hedge against market downturns.
Alternative investments are considered an effective way to balance risk in a portfolio and to provide a "cushion" in the case of a stock or bond meltdown and are appropriate in a small portion of your overall portfolio.
Even if you look at your portfolio and don't directly see something that you recognize as an alternative investment, they may be there as ETFs or funds, as well as many large institutional funds such as pensions and even retirement fund offerings, that have alternative investments in them.
Retail firms may even recommend allocation models for clients with alternatives near or above 20% of a portfolio. Every client is different and allocations will vary based on their needs, but a current discussion with your financial advisor will probably include the topic of alternative investments in your portfolio.
Many people typically associate a hedge fund as the most common alternative investment and for many investors, that's true. Most hedge funds, though, are available only to large investors and require a significant amount of paperwork, high fees, and tax headaches. Many investors are achieving exposure to alternative investments through liquid alternatives such as mutual funds, ETFs, and closed-end funds that provide daily liquidity, but have complex investment strategies that seek to retain their non-correlated status.
Should Alternative Investments Be in My Portfolio?
Some financial advisors may feel that the inclusion of alternative investments is a prudent aspect of asset allocation for retirement accounts. An advisor might allocate 5-10% of your retirement portfolio to this non-correlated investment class. If you wanted the alternative investment to be in some type of cryptocurrency or related asset, this investment may be a rocky one until the cryptocurrency market matures.
The investment performance will also vary based on how you choose to invest in cryptocurrency. You can invest directly in a cryptocurrency such as Bitcoin or Ethereum, or over 1,400 others in existence (with new ones continually appearing), a company involved in developing blockchain technology, or firms that have specialized equipment that's involved in mining cryptocurrency.
The investments that are traditionally called alternative investments include gold and hedge funds, and they can provide good, solid returns, but they've been inconsistent performers of late. The average hedge fund returned about 8.5% in 2017 which doesn't sound bad until you compare it with the S&P 500's return for the same time period. Tracking the value of gold through the GLD ETF indicates that its 3-year and 5-year numbers are in negative territory, although the 2017 one-year return was positive at 12.81%.
It probably won't be long before you see an ETF made up of companies pursuing Blockchain technology as an alternative investment option. Some hedge funds are already including Bitcoin into their portfolios, and there are probably hedge funds that already have Bitcoin and blockchain startups that may one day be publicly traded companies in their portfolios. If a hedge fund is considered an alternative investment and they're already using Bitcoin, then at some point firms and the media will start to openly declare Bitcoin as an alternative investment as well.
Cryptocurrencies Beyond Bitcoin
If you're a very aggressive investor, you may want to look at other cryptocurrencies aside from Bitcoin. That's right, Bitcoin is not the only digital currency. In fact, there are exchanges that buy and sell each day many of these different cryptocurrencies, including ETH (Ethereum), which has soared in price, or XRP which is from Ripple Labs and is being used in blockchain projects involving existing banks.
Thus far, there aren't any products available from traditional or online brokers that will easily allow you to invest in cryptocurrencies, outside of doing so on your own by opening an account with one of the exchanges that buy and sell them, such as Poloniex. But they're coming.
Even with all of this current and future activity, it doesn't seem that any firm, advisor or publication has explicitly classified Bitcoin or any other cryptocurrency as an alternative investment. There's little doubt that they're non-correlated to stocks and bonds. They could even be considered a currency (in fact, they were the best-performing currency in 2015).
The point here is not to convince readers to invest in Bitcoin, GBTC (Grayscale Bitcoin Investment Trust) or other cryptocurrencies, but to inform them that many others are doing it.
As with any investment, some are making money with it and others are losing money with it. These investments are not for the faint of heart, but it's a growing and very real investment opportunity.
Many investors are still skeptical and think that Bitcoin is nothing more than a Ponzi scheme. However, companies like Overstock.com, eBay, Amazon, Target, and Expedia are now accepting it as a form of currency similar to credit cards.
Due to the complex nature of blockchain technology (the underlying infrastructure of Bitcoin), many don't yet understand it and feel it's of little value, but finance companies like Bank of America, Merrill Lynch, Citi, Credit Suisse, and JPMorgan, John Hancock and the DTCC are running tests with it to improve their current processes.
Consider Alternative Investments as Part of a Portfolio
The time has almost arrived for investors and financial firms to classify investing in Bitcoin, cryptocurrencies and blockchain-based technologies as alternative investments, and thus having a place in a properly allocated investment portfolio. Over the next few years, it's clear there will be more and more opportunities to invest in them. As these investment opportunities open up, they need to be classified appropriately in order to be placed in investor portfolios using proper asset allocation models.
Many people will dismiss them, potentially including your advisor. With the progress (and profits) being made, however, over the next year or two, you might start hearing a lot more about how they may fulfill the alternative investment portion of your portfolio.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.