Table of Contents
Introduction
Investors have recently focused on traditional investments like stocks, bonds, and mutual funds. However, as markets evolve, there has been a growing need for investors to diversify their portfolios, leading to an increase in alternative investments. Alternative investments mean investing in unconventional financial assets, like real estate, commodities, and hedge funds. These assets provide investors with diversity, growth, and income that traditional assets may not obtain. This guide will help you understand the concept of alternative investments by exploring their types, benefits, risks, and suitability for various investors.
Types of Alternative Investments
Going into alternative investments requires understanding that each option has varying capital requirements and demands. These alternative investments are real estate, commodities, and hedge funds.
Real Estate
Real estate is a physical asset that involves buying, managing, and selling landed properties for profit. Investing in real estate includes land, improvements, and natural resources. It has a high capital appreciation, making it a suitable investment. The types of real estate options are:
Residential real estate refers to any property used for residential purposes. This includes family units, apartment buildings, duplexes, and condos. Investors can make profits by receiving rent from tenants.
Commercial real estate refers to any property used for business. Examples include office buildings, shopping centers, restaurants, hotels, and retail spaces. Commercial properties have higher returns than residential properties.
Industrial properties include renting out manufacturing, production, research, and distribution spaces, such as warehouses and factories.
Land: This refers to leasing out an undeveloped property. They are usually leased out for agricultural purposes.
REITs (Real Estate Investment Trusts): REITs companies own, manage and finance revenue-generating real estate. Investors can profit from real estate without directly owning or managing properties.
Commodities
Commodities are physical goods that are commonly regulated and traded on financial markets. Commodity investing can involve buying actual goods, investing in commodity ETFs and mutual funds, or using commodity trading platforms. Tradeable commodities include:
Energy products: Energy products like crude oil are essential to the world economy. Investing in energy products can give investors access to a portion of the global economy.
Precious metals, such as gold, silver, platinum, and diamonds, are low-risk, high-return products that can provide financial security against economic fluctuations. They should be kept in secure environments, such as banks, and safe deposit boxes are advisable.
Agricultural products: Investing in agrarian products like wheat, cassava, and cocoa can be lucrative, as food is an important economic component. While the prices of agricultural products heavily rely on market demand and climate changes, they are still likely to have a high yield due to their constant need.
Hedge Funds
Hedge funds are investment funds gathered from private investors that are used to gain active returns for their investors. They involve investing in diverse options like equities, commodities, and currencies through various strategies. They are usually open to investors with a robust investment portfolio.
Hedge fund strategies
Event-driven strategy: This involves taking advantage of a reduction in stock prices, usually caused by corporate events like mergers and acquisitions, bankruptcies, and takeovers.
Case Study
In 2022, MTN Group, an African mobile operator, and Telkom, a semi-privatized telecommunications company in South Africa, entered into merger talks. This led to investors taking advantage of the drop in Telkom’s stock prices and foreseeing the merger’s benefits. Although the negotiations were called off, the actions of these event-driven investors show how events determine investors’ actions.
Long/short strategy: This is when investors buy stocks that are expected to increase in value and sell stocks that are expected to crash, profiting from market fluctuations.
Case Study
During the 2020 COVID-19 pandemic, Coronation Fund Managers, a South African company, saw opportunities in the healthcare sector. After weighing the increase in demand in the healthcare sector, they increased their investments by buying large amounts of stocks in pharmaceutical companies like Aspen Pharmacare. On the other hand, they reduced their stocks in the hospitality and travel sectors due to the worldwide travel restrictions and lockdowns. By closely monitoring economic trends, they could make strategic investment decisions.
Global Macro strategy involves investing based on economic and political global trends. Investors might buy or sell stocks, bonds, and commodities based on these trends. Case StudyDuring the European economic crisis, Brevan Howard, a European hedge fund management company, predicted financial instability among Eurozone countries. They shortened their European bonds in countries like Greece and Spain. They also invested in safer bonds in stable economies like the US. This strategy was used by saved Brevan Howard as the economic crisis continued.
Quantitative strategy: This strategy relies on computer algorithms, data analysis, and technology in general to find trading opportunities and make investment decisions. Using technological tools, investors can make sound investment decisions by analyzing a large amount of data based on statistics.
Benefits of Alternative Investments
The attractions of alternative investments are in their potential to bring diversification into investment portfolios, mitigate asset risks, and increase profit. By investing in unconventional markets, they can provide a hedge in case of market volatility. Alternative investments also help to develop good investment strategies that can be used even in traditional investments.
Diversification
One of the advantages of alternative investments is that they allow for a diversified portfolio. As a young investor, you can make traditional and alternative investments, reducing risks. While traditional investments, like stocks and bonds, usually move in the same market cycles, alternative assets, like commodities and property investments, move in a different direction. For example, real estate can perform well in the same economy where stocks are underperforming, acting as a buffer against market unpredictability.
Inflation Buffer
In cases of inflation, alternative investments like real estate and commodities increase in value along with inflation. Not only is the investor’s capital preserved, but the return on investment can grow beyond earlier predictions. For example, using the global macro strategy, hedge funds will likely make excess returns during global inflation.
Higher returns
Alternative investments can generate higher returns compared to traditional investments. For instance, real estate investments usually increase in value, especially in high-growth markets. They offer substantial investment and income growth, not to mention that they are tangible assets.
Access to Unique Opportunities
Alternative investments give investors access to worldwide markets that are not available with traditional investment vehicles. They are also exposed to advanced financial strategies. For instance, alternative investments allow the opportunity to invest in start-up companies before they go public.
Increased Portfolio durability
Including alternative investments in the portfolio can help it remain resilient during the market and economic decline. In cases where traditional assets suffer, alternative investments tend to rise with inflation. Also, the strategies employed by hedge funds can help you make profits even during market downturns.
Risks of Alternative Investments
Illiquid Asset Risk
Illiquidity refers to the risk that an asset will be complex to sell quickly without affecting its value. Alternative investments like real estate can be comparatively illiquid, unlike stocks and bonds that can be sold on public financial markets. Assets can be complex to sell when there are unwilling buyers, and alternative investments might not be easily accessible when investors need their capital.
Complexity and Lack of Transparency
Alternative investments like hedge funds involve complex structures and methods that can be hard for investors to understand. Investors who want to add alternative investments to their portfolios must educate themselves on the structures of these assets and make informed decisions. Also, when investors do not understand how their money is being managed or invested, it can lead to a lack of transparency. Some alternative investments operate privately, making it harder for investors to monitor performance.
High charges
When deciding on alternative investments, it is essential to consider the fees associated with them. Management and performance fees can significantly diminish the potential profits of the investments. Real estate investments, for example, can involve maintenance costs and management fees. Investors should weigh the fees and potential returns and ensure that profit outweighs cost. This analysis will help the investor make informed investment decisions.
Regulatory Exposure
This refers to how changes in government policies, rules, and laws affect alternative investments. Investments like hedge funds can face unexpected policy changes, affecting their operations and potential revenue. Investors are advised to be informed about regulations and their influence on the value of their investments.
Economic Risk
While unconventional investments will likely yield high profits, they are not invulnerable to market volatility. Economic downturns and shifts in local financial markets can lead to declining investment values, and natural disasters and geopolitical events can affect real estate values and hedge funds.
Suitability of Alternative Investments
The suitability of alternative investment depends on different investors and their investment goals, risk-taking, and investment time horizon. Alternative investments are best when they sync with the investor’s portfolio and goals. Investors might consider various investment options depending on their preferences, requirements, and objectives. Let’s see the kinds of investors that can go into alternative investments:
Retail Investors
The suitability of alternative investments for retail investors depends on their portfolio goals, finances, and risk tolerance. Retail investors can consider investments in:
Real Estate Investment Trusts (REITs): This requires little capital to invest in real estate without owning any property.
Commodities: retail investors can invest what they can afford by buying assets like gold in small quantities.
Hedge funds: retail investors can join in gathering money for investment. They can add what they can spare.
Institutional Investors
Institutional investors, like insurance companies, usually have a lot of financial resources and expertise to invest in unconventional assets with long investment horizons. Due to their large size, they can make investment decisions that retail investors may need access to. Those investments include:
Hedge Funds: With the use of various strategies, they can afford to invest heavily to generate high returns
Infrastructure: Institutional investors can invest in projects like toll roads or renewable energy to provide high returns
Real estate: they can invest in many properties for potential income generation.
High-Net-Worth Individuals
High-net-worth individuals (HNWIs) are investors with large traditional investment portfolios. They usually have high capital and are willing to take higher risks for potential capital appreciation. They can allocate part of their assets to hedge funds, real estate, and private equity.
Accredited Investors
Accredited investors are those who meet a specific income and net worth requirement. They are usually privy to private investment opportunities and unregistered investments. These investors thoroughly research the risks, benefits, and strategy before investing. They can access all alternative investments, such as hedge funds and private equities.
Before deciding what alternative asset to invest in, investors review their portfolios, investment goals, diversification strategy, and risk tolerance. Investors should also understand that alternative investments should serve as complements to traditional assets and not replace them. It is advisable that no matter the asset an investor wants to invest in, he should consult market experts and be well informed.
Frequently Asked Questions (FAQs)
1. What are alternative investments?
Alternative investments are assets beyond traditional investments, such as real estate, commodities, and hedge funds, providing diversification to an investor’s portfolio
2. Why should I consider alternative investments?
They offer potentially higher returns, a hedge against economic fluctuations, and diversification in investment portfolios.
3. What types of alternative investments can I invest in?
Alternative investment options include real estate, commodities like gold, and hedge funds.
4. What is a hedge fund?
A hedge fund pools capital from several investors to invest in various assets using different strategies and for a potential profit.
5. How does liquidity affect alternative investments?
Investments like real estate can take time to liquidate quickly, especially during economic downturns.
Conclusion
Alternative investments are pivotal in diversifying your investments. It is advantageous to conduct market research and choose the best investment option. Despite the value of an investment, it is best to note that it has risks and limitations. It is recommended that investors be vigilant, monitor market conditions, and modify their strategy and portfolio as the need arises. By staying informed, investors are able to reach their financial goals and earn financial stability.
