Alternative investments are assets and strategies outside traditional investments like stocks, bonds, and cash. They can provide diversification, hedge against inflation, and generate higher returns for investors. However, due diligence is required, given these assets' complexity and lower transparency.
What is alternative investing?
Alternative investments typically have the following characteristics:
- Specialized investment managers with a narrow focus.
- Low correlation to traditional assets.
- Less regulation and transparency.
- Illiquidity and longer time horizons.
- Higher fees than traditional investments.
While riskier than traditional investments, especially dividend stocks, alternatives can provide portfolio diversification and the potential for higher returns.
Alternative investments categories
The major categories of alternative investments include:
- Real estate.
- Private equity investments.
- Hedge funds.
We review each of these investment types below.
Types of alternative investments
The following table provides a broad overview of five different alternative investment types. Please note that the table includes general guidelines, and the specific allocation for each investor will depend on their investment goals, time horizon, and risk tolerance.
Real estate is an attractive investment in Canada because it provides portfolio diversification, inflation hedging, and income generation.
There are several ways to invest in real estate, including rental properties, partnerships, real estate investment trusts (REITs), and crowdfunding.
Key benefits of real estate include income potential from rent and appreciation over time. Real estate also has a low correlation to stocks and bonds.
Private equity allows investors to invest in fast-growing startups with potential returns exceeding public markets. These companies are not listed on public stock exchanges.
The three main private equity strategies are:
- Venture capital: Investing in startups and early-stage companies. High risk but high growth potential.
- Growth equity: Providing capital to expand established mid-sized companies. Lower risk than venture capital.
- Leveraged buyouts: Using debt to acquire mature companies. Company cash flow pays down acquisition debt.
Private equity funds are illiquid. Investors may also need accredited investor status. Minimums are high, often over $100,000. And so are the management fees and, potentially, performance fees. But the return can be well worth it for suitable high-net-worth individuals.
Hedge funds are actively managed and use risky strategies like short-selling and leverage. The long/short approach combines these two stock positions, providing lower market risk than long-only funds. Event-driven investing includes betting on mergers, bankruptcies, and corporate restructuring. A global macro approach involves top-down trading based on macroeconomic trends and events.
Hedge funds provide diversification from traditional assets. Even pension funds are now staking positions in these investment vehicles. However, the risk strategies mean they are prone to losing money in down markets. High minimum investments are common.
Commodities are physical assets like precious metals, energy, livestock, and agro-products. Commodity investments hedge against inflation and provide significant portfolio diversification.
Ways to invest in commodities include:
- Owning physical assets, like gold bullion.
- Commodity Exchange-Traded Funds (ETFs), which are alternative funds that track asset prices.
- Commodity futures that allow buying or selling commodities at a preset price in the future.
Gold and oil are popular commodities for Canadian investors. Gold can hedge stock market crashes, while oil provides exposure to Canadian energy resources.
Crypto, like Bitcoin or Ethereum, are digital assets blockchain technology secures. Cryptocurrencies offer potential upside but have high volatility and a higher risk, similar to technology stocks.
Investors typically buy cryptocurrencies directly. However, in recent years, crypto ETFs and futures have gained popularity.
Many advisors recommend limiting crypto to 1-5% of a portfolio due to the high risk and volatility.
Benefits of alternative investments and why they matter
Used judiciously, alternatives can enhance portfolio diversification and performance, and provide hedging against inflation. Here are some key benefits in detail:
- Diversification: Alternatives tend to have a low correlation to traditional financial assets like stocks in public companies and bonds. Adding them to investing strategies can reduce overall volatility and risk.
- Performance: Alternatives, like private equity, venture capital, and hedge funds, aim to generate higher returns than public markets. However, higher rewards typically come with higher risks.
- Inflation hedging: Real assets like commodities and real estate can hold their value better during inflationary periods than stocks and bonds.
- Unique opportunities: Alternatives provide exposure to niche asset classes, strategies, and markets that aren’t accessible through mainstream investments. Early-stage investments in small private companies are an excellent example of such opportunities. However, these might be long-term investments.
- Tax advantages: Some alternatives, like real estate partnerships, offer tax benefits not available with stocks and bonds. This can improve after-tax returns.
- Customization: The range of alternative investments allows more flexibility to tailor portfolios to specific goals, risk preferences, and market outlooks.
Alternatives potentially come with illiquidity, complexity, higher fees, and other risks to consider. Detailed due diligence is vital before allocating to alternatives.
How to unlock the potential of alternative investments
Here are some ways to enter alternative markets with confidence.
- Understand the risks, fees, liquidity, and potential returns. Only invest with expansive research and due diligence.
- Work with a qualified financial advisor or investment manager with experience in alternatives. Their expertise will help mitigate risks.
- Start small to test an alternative investment. Limit allocation to 5-10% of your overall portfolio.
- Focus on liquid alternatives like REITs and commodity ETFs if you need access to your capital. More illiquid options like private equity require long time horizons.
- Consider diversified funds like multi-strategy hedge funds to get exposure to different alternative strategies in one investment.
- Look for alternatives uncorrelated to the stock market to realize diversification benefits like managed future funds.
- Ensure you meet accredited investor requirements for private securities like private equity and hedge funds.
- Hold alternatives in retirement accounts to maximize tax efficiency if suitable based on liquidity needs.
- Regularly rebalance your portfolio to maintain target allocations to alternative investments.
- Accept higher volatility and illiquidity as a trade-off for the diversification and return potential benefits alternatives can offer.
The key is conducting diligent research, starting small, focusing on liquidity needs, and diversifying across different alternative strategies and asset classes. Alternatives can enhance portfolio performance and risk management if used prudently.
Alternative investments can enhance investment portfolio diversification and returns for suitable Canadian investors. Real estate, private equity, hedge funds, commodities, and cryptocurrencies present opportunities outside traditional stocks and bonds. However, alternatives have unique risks, so extensive due diligence is needed.