As we can read on the CFA Institute website, the distinction between 'traditional' and 'alternative' investments is merely intended to distinguish between the typical investment instruments listed on the stock exchange, such as shares, bonds, ETFs, funds, etc., and the other forms of investment that exist in the alternative markets and are anything but new; in this sense, we need only think of the case of the physical purchase of precious metals such as gold. First of all, it should be clarified that these are investments that are almost exclusively reserved for institutional investors or holders of large fortunes (high net worth individuals), due to certain specific characteristics of these assets, such as low liquidity, high management and access costs, etc. In the investment portfolios of professionals and high net worth individuals, these investments usually play a diversification role. Because of their complexity, they are almost exclusively the domain of active management.
What are alternative investments?
Alternative investments exist in markets that are unregulated or less regulated than traditional markets (such as equities and bonds). They include a wide range of assets, such as real estate, hedge funds, venture capital or private equity, commodities and even art, luxury spirits and collectibles. These investments are characterised by their low correlation with traditional financial markets, which makes them attractive to those seeking to diversify their portfolio and reduce the risks associated with traditional markets.
The main assets of alternative investments
- Real estate. This is an investment in real physical property, such as land, houses, offices, commercial premises, etc., from which it is possible to obtain a return a) by renting and b) by buying and selling. It is almost taken for granted that these are complicated investments, which certainly require specific professional skills or a lot of time (just think of what it meant for many to buy their first home or rent a property), long investment periods and attention to the market situation in order to reap real benefits.
- Hedge funds. Also known as 'hedge funds', these funds seek high returns by using complex or risky investment strategies, such as leverage and arbitrage, and complex products for professionals, such as derivatives. They are also governed by different rules than traditional funds, so it is not surprising that they are funds that are off-limits to small investors/savers.
- Private equity. This is the name given to a set of investments linked to venture capital, identifiable as a constellation of investments in unlisted companies. While it is true that in certain cases these investments promise high returns (at least in terms of performance), they are onerous investments that are designed to last for a long time, as they are aimed at specific corporate financial operations, such as covering the costs of a start-up, expansion, restructuring or acquisition; hence the limited liquidity of the investment in question.
- Commodities. Investing in commodities means a) physically buying an asset, b) entering into a futures contract. The sector is very broad, ranging from precious metals to energy commodities, from agricultural products to industrial metals. According to experts in the field, some of them can offer a degree of portfolio diversification because they are decoupled from traditional financial markets, although they are often more risky on average or more complicated to manage (think of futures or physical gold).
- Works of art, fine spirits and collectibles. Why buy a painting in an art gallery, a very expensive bottle of whisky, a stamp or a rare coin? The idea is simple: their value can increase over time. But there is no shortage of risks: you have to know which objects are really valuable, you have to bet on the right ones (paintings, spirits, stamps, coins, etc. can go up in value but also depreciate) and it is often complex to find buyers willing to pay a fair price: you need to have a thorough knowledge of the market in question.
- Private debt. This type of investment arises from the need of some economic operators to finance themselves without going through traditional credit channels, or from the need of those economic operators who cannot (for the same purpose) issue bonds because they are unlisted companies: other operators may then be interested in providing loans in the form of investment projects in exchange for interest. In short, and to a large extent, it is an alternative bond market in which private debt plays the role of bonds; it usually offers higher average interest rates than bonds, but also higher risks and lower liquidity than bonds.
- Infrastructure. Investment projects in key utilities and facilities such as roads, bridges, airports, water and energy networks are considered by experts to have the potential to pay back investors over time; however, they require large amounts of initial investment capital and the need to tie up this capital for a long period of time as the investment horizon is long term due to their size.
- Cryptocurrencies and digital tokens. There are those who include cryptoassets, i.e. digital currencies such as bitcoins or other assets based on blockchain technology (e.g. NFTs), among alternative investments, but it is clear that these are speculative assets characterised by very high volatility.
What are the risks?
- Low liquidity. Selling an alternative investment quickly and at a fair price is usually not an easy task: the absence of highly regulated markets, but also the long-term horizon, means that these investments do not enjoy the same liquidity as traditional assets such as equities or bonds.
- Complexity and transparency. The systematic mechanism of market quotations, reflected in the constant updating of prices, does not apply to alternative investments: they are both opaque and complex to price; the absence of a market price therefore makes it more difficult to assess their risks and potential returns.
- High costs. This complexity also brings with it the need for professional management, so the fees and management costs for alternative investments are usually significantly higher than for traditional investments.
- High risk of loss. The risk of losing capital is particularly high if you need to liquidate investments prematurely or if you hold assets that are inherently volatile.
What are the benefits of investing in alternative assets?
The existence of alternative assets and the interest of investors in this market can be explained by the role that these assets can play in the portfolios of institutional investors or high net worth individuals, as mentioned above.
- Diversification. As mentioned above, professional investors tend to include alternative assets in their portfolios with the aim of diversifying the portfolio, given the low, zero or inverse correlation of alternative assets with traditional assets.
- High return prospects. Alternative investment professionals point to investments that, while risky, have the potential to generate higher returns than traditional markets under certain conditions.
- Protection against inflation. Investing in real assets such as property or commodities can offer a hedge against inflation, as some of them (as is often the case with houses and gold, for example) tend to increase in value over time precisely because of the loss of purchasing power associated with money.
European long-term investment funds
However, retail investors are not completely excluded from investing in alternative assets. One example is the European Long-Term Investment Funds (ELTIFs), investment vehicles regulated by the European Union whose purpose is to finance investments in infrastructure projects or companies that are not listed on the markets. These funds comply with European regulations, which include criteria that increase their transparency and guarantee a certain level of protection for investors. However, they are still characterised by the search for higher market returns, at the natural cost of higher risks, which is why it is advisable for retail investors to seek the help of an investment professional before making such choices, in order to verify that such investments are in line with their investment objectives and personal risk tolerance.
Read also
What are financial derivatives? Futures, Forwards, Options and Swaps
What are the main management styles with regard to the benchmark?
