Your investment portfolio will typically include conventional investments such as stocks and bonds both equally important parts of a solid, long-term investment strategy. But, there are many other less-typical investments that can supplement your portfolio and provide you with opportunities to reduce some of the effects of market fluctuations. Consider alternative investments such as commodities, hedge funds, mutual funds with alternative strategies, and futures to round off your portfolio.
What are alternative investments?
Alternative investments are asset classes that generally don't move together with traditional equity and fixed income markets. They usually follow their own cycles. As a result, alternative asset classes have a low correlation with standard asset classes; therefore they may help diversify your portfolio by reducing the overall volatility of the portfolio when traditional asset classes such as stocks and bonds are performing poorly.
Historically, alternative investments have been restricted to high-net worth individuals and institutional investors, but these days they are far more available to a wider audience. Alternative investments range from real estate to hedge funds to commodities and can complement a variety of investing strategies. However, they are designed to complement a well-founded portfolio rather than to serve as the focal point of the portfolio.
Most people are attracted to alternative investment because they may yield a higher return than traditional investments, but note that potentially higher returns also may carry higher risks with them. What's important to note is that alternative investments may be more illiquid than their conventional counterparts - they cannot be sold readily like stocks and bonds - and some may need to be held for a longer time horizon. Additionally, there may be unique fees or tax consequences.
Alternative investment options for your portfolio
There are many investment products available today and it sometimes may be difficult to clearly identify which investments are conventional or alternative. But below are is a list of common alternative investments along with their potential benefits and risks.
Including a small portion of your portfolio toward precious metals such as gold or silver may offset the performance of other assets in the portfolio such as stocks and bonds, because precious metals typically don't move in tandem with conventional investments.
Gold is typically viewed as a hedge against inflation and currency fluctuations. So when inflation effects the purchasing power of a currency - say the dollar weakens against the euro - gold prices tend to rise. As a result, investors place their money in gold during economic and market downturns.
Investing in gold can be accomplished in several ways, including futures funds, exchange-traded funds, mutual funds, bars, and coins. Nevertheless, since precious metals make up a small sector, prices often change dramatically. This type of volatility can create opportunities for investors in the form of high returns but it can equally result in dramatic losses.
Hedge fund offerings
Hedge funds have historically been available only to high-net-worth individuals and institutions. Hedge funds are investment pools that manage money for institutions like banks, insurance companies, as well as individuals who meet the federal definition of a "qualified purchaser" in terms of net worth and income.
Hedge funds are typically organized as limited partnerships where the fund managers are the general partners and the investors are the limited partners. Hedge fund investments tend to have limited liquidity on a scheduled basis as a result these alternative investments are subject to special regulatory requirements different from mutual funds.
Funds of hedge funds invest in a variety of hedge funds with many different strategies and asset classes with the purpose of reducing overall fund risk through increased diversification. Fund of hedge funds are available to investors that meet the accredited net worth standards of at least $1 million. Fees of hedge funds are higher because of the type of portfolio management and increased trading costs.
Fund of hedge funds are registered with the SEC under the Investment Company Act of 1940 and as securities under the Securities Act of 1933. They may also come in the form of a private offering which will need to adhere to stricter accredited investor standards. Fund of hedge funds can be complicated investment vehicles which often use leverage, lack transparency, may be subject to restrictions, and may include other speculative practices.
Mutual funds with alternative strategies
Mutual funds are offered in many asset categories, including real estate and commodities. Some mutual funds can mimic hedge fund strategies and may be a good option if you're interested in alternative investments but don't meet the accredited investor standards.
In contrast to hedge funds and fund of hedge funds with their higher fees and possible restricted liquidity, these types of mutual funds are relatively low cost and are very liquid - they can easily be bought or sold in a public market. As a result they are accessible to a wider range of investors and therefore mutual funds with alternative strategies are prohibited by law in using high leveraging to boost yields as is common with many hedge funds.
Nevertheless, alternative mutual funds do use aspects of hedge fund investing such as employing both long- and short- investment tactics, trading complex derivative products, and short selling. If you are an investor that is looking to help offset market swings or specific sector swings and you understand the risks that may be involved investing in alternative investments, alternative mutual funds may be something to consider adding to your portfolio.
Managed futures funds
Managed futures funds are formed for the purpose of investing assets in the investment vehicles and trading strategies deemed appropriate by commodity trading advisors (CTAs). These specialized money managers use futures, forwards, options contracts and other derivate products traded in U.S. and global markets as their investment vehicles. CTAs are required to be licensed and are subject to the regulations of the National Futures Association and the Commodities Trading Futures Commission (CFTC).
Managed futures are speculative in nature, involving high risks, may carry higher fees, and have limited liquidity. Nevertheless, managed futures investments have been popular investments for high-net-worth individuals and institutional investors for the past several decades. Their appeal comes from their ability to provide investors with greater portfolio diversity by increasing exposure to global investment opportunities and other sectors such as commodities.
There are several categories of managed futures in terms of structure and investment objectives. They may be available to investors in the form of a private offering subject to higher accredited investor standards according Regulation D guidelines of the Securities Act of 1933.
Real estate investment trusts
A popular type of alternative investment is commercial real estate. Until recently commercial real estate has been mostly inaccessible to retail investors and was widely enjoyed by high-net-worth individuals and institutional investors for its potentially higher yields and diversification attributes. Since the inception of real estate investment trusts (REITs), investing in commercial real estate has become available to wider range of investors.
REITs pool money from investors and invest the funds in properties ranging from office buildings to apartment complexes to hospitals and warehouses. REITs are offered to investors in two forms: traded and non-traded. Both offer exposure to commercial real estate assets.
Publicly traded REITs can be easily bought and sold on a daily basis on active secondary market. However, they tend to be more volatile.
Non-traded REITs are illiquid investments appropriate for investors with a long-term investment time horizon of at least 5 to 10 years. Non-traded REITs are not aligned with stock and bond market movements so they add great diversification to a portfolio.
Alternative investment can also include assets such as art, gems, rare collectibles, and antiques. In addition, venture-capital funds are considered alternative investments. These alternative investments can help provide investors with added diversification and can help balance out performance across various market swings.
Considering alternative investments
Alternative investments can potentially boost your portfolios returns while helping you reduce market exposure and overall portfolio volatility. However, because of a lack of a secondary market for some alternative investments and restricted liquidity for others, as well as the higher risks associated with them, alternative investments should be used as complements to traditional portfolios consisting of equities and fixed-income instruments.
Moreover, because alternative investments often require more professional management than conventional investments, it's important to look to experienced money managers for help such as your Financial Advisor.
Alternative investments include gold, real estate, hedge funds, funds of hedge funds, commodities along with others and are generally used to round off your portfolio's performance because alternative investments are typically not correlated to traditional markets such as equities and fixed income.
Alternative investments are often illiquid, with longer investment time horizons and carry higher risks, and often require professional money managers.
Investors must meet a criteria outlined by the law, ranging from product to product, in order to take advantage of alternative investment opportunities.
Alternative investments should generally be used to complement existing portfolios and strategies consisting of mainly stocks and fixed-income products.
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