What is an Alternative Asset?

FORECASTS & TRENDS E-LETTER
by Spencer Wright
October 22, 2024

IN THIS ISSUE:

The Definition of an Alternative Asset
The Benefits, Risks and Examples
Final Thoughts

Investors have experienced uncertain and sometimes volatile market conditions over the last several years. Because of this, many advisors are introducing their clients to alternative investments with the goal of portfolio diversification with reduced volatility. Today we define alternative investment and give some common examples. Over the next several weeks, we will delve more deeply into the world of alternative investments and why “alts” have become more utilized in the investment community.

The Definition of an Alternative Asset

Alternative asset is a term that has become more and more popular over the past decade. It can seem like almost anything can be labeled an alternative asset. It is easiest to define alternative assets by what they are not. They are not traditional assets, those being standard equities such as stocks, ETPs, and mutual funds as well as traditional debt instruments like treasury bonds, corporate bonds, and other fixed income issues.

Assets that fall outside of the above can be considered alternative assets.

Investopedia rightly states that “alternatives can include private equity or venture capital, hedge funds, managed futures, art and antiques, commodities, and derivatives contracts. Real estate is also often classified as an alternative investment.”

The Benefits, Risks and Examples

Alternative assets cover a broad area. We will examine some alternatives in detail below. First, consider this chart that does a good job of addressing the potential benefits and risks of alternatives.

Chart comparing traditional investments to alternative investments

The major risk of alternatives is potential illiquidity. While non-institutional investor alternatives are reasonably liquid on a historical basis, that is not the same as highly or fully liquid like more traditional assets. If you are considering alternatives, be sure to request a liquidity schedule.

The major benefit of alternative assets is non-correlated returns. Returns that are not typically influenced by the movements of traditional global markets. Thus, alternatives have the potential to deliver returns on an absolute basis.

Alternative assets have been widely used by institutional investors for a very long time. Such investors include pension funds, university endowments, large charitable organizations and family offices. These participants are often referred to as ‘smart money’ investors as they generally sport impressive investment track records over long periods of time.

Consider this graphic that shows how some of the major university endowments have allocated their assets as recently as 2021.

Chart that shows four major endowments that hold alternative investments

Each of these institutions uses a very high concentration of alternative assets. It is important to remember that these institutions have goals and investment objectives that may differ significantly from those of non-institutional investors. This chart does demonstrate the positive potential of alternative assets.

Let’s look at some of the most common alternative assets.

Real Estate: This is by far the best known of alternative assets. Real estate as an investment includes investing in physical properties or property-based securities. It can include investing in real estate investment trusts (REITs), and real estate mutual funds. These funds can be publicly or privately offered. In addition to capital appreciation, investors strive for operating income to provide ongoing, stable cash flow.

Private Equity: This alternative asset has been a go-to investment of institutions for decades. Now, private equity is more available to higher level retail investors. Unlike real estate, the private equity structure can be hard to follow. This graphic from Investopedia does a great job explaining the private equity structure.

Chart that explains the structure of a limited partnership

Instead of holding stocks like other traditional equity assets, private equity funds hold entire companies. In some cases, these portfolio companies are bought, improved and sold, or bought and held. Some funds might have a lifespan of a predetermined number of years, some might be on-going.

Hedge Funds: This is a very broad term these days that has become an almost generic reference to alternative assets. A modern hedge fund can hold nearly anything and employ a truly dizzying array of strategies. Statistics show that the majority of so-called hedge funds do not out-perform standard benchmarks. Although a feature of many hedge funds is to make money regardless of the market environment. A common type of hedge fund is the global macro fund. These funds often trade in currencies, global equities, energy and commodity futures contracts.

Private Credit: Private credit funds loan investor money to companies that may have trouble accessing capital through traditional markets or to companies that only need the funds for a short period of time. These funds often focus on generating total returns for investors but can also provide a source of income.

Quantitative Long/Short: With the rise of computers and AI, quantitative funds have proliferated. These are funds driven by mathematical algorithms, devoid of human input or emotion. Many such funds trade in the long / short space. Meaning that the funds trade both long and short on major indexes or commodities or even individual stocks.

Final Thoughts

Alternatives aren’t for everyone, just as no investment is right for every investor.

Today, alternative assets are more available to retail investors than at any other time. Alternatives can provide important diversification at the portfolio level by providing non-correlated and or asymmetric returns. However, as mentioned above, investors should be aware that liquidity is likely limited if the investment is privately offered. Always ask for a liquidity schedule.

Thanks for reading,