During uncertain times such as these, the stock market has a tendency to become less predictable — driving away investors who don’t enjoy riding a daily rollercoaster of emotions.
With interest rates rising, bonds aren’t a great place to invest either and could be poised for their worst year in decades. This volatile environment may leave some investors seeking a stable place to put their money but uncertain where to turn.
For experienced investors, the world of alternative investments might be an option, providing diversification and the potential for higher returns while reducing concern about the day-to-day fluctuations of the stock market.
What are alternative investments?
“Alternative investments” is a blanket term to describe a wide variety of specialized asset classes that don’t fit into traditional liquid categories such as listed stocks and bonds. Some examples are:
• Real estate: This could mean anything from investing in a single property to holding a share in a diversified real estate fund that directly owns hundreds of properties, or even a fund that develops real estate from the ground up.
• Private equity: Investors pool their money in investment funds that directly buy a stake in one or several non-public companies, hold it for a period of time (typically years), then hope to profit when the company is sold, their stake is bought out by another group of investors, or the company goes public in an IPO.
• Private credit: This involves investor groups lending money directly to businesses, similar to a bank. As banks have cut back on higher-risk business loans over the past decade, private investor groups have increasingly stepped in to meet the need — and as a result, are in a position to charge borrowers a higher interest rate that can be distributed to investors as income.
• Hedge funds: These are structured investment funds with various kinds of investments under one umbrella that are typically taking long and short positions at the same time in different liquid securities, such as stocks or bonds. While they are typically meant to have less risk than the equity market, they also use leverage (making investments using borrowed money), leading to a different type of risk, of which investors need to beware.
• Infrastructure: When cities or states require money to fund large projects, like airports, seaports or highways, they sometimes turn to large private investment funds, which can help provide the necessary funds.
Alternatives have been growing in importance in recent years for a few reasons, among them some recent regulatory changes. In 2020, the SEC amended and expanded its definition of an accredited investor, a special status that had previously been reserved for certain experienced or wealthy investors.
While this democratization of alternatives makes it possible for a larger group of investors to participate, that doesn’t mean they’re the best choice for every person.
Pros and cons
The biggest difference from traditional investments is that alternative investments are illiquid, meaning they’re not easily priced or bought and sold like a typical stock or bond. While a stock typically settles in two days, it might take as much as 90 days or more for a real estate investment, as an example. Also, many alternative fund managers require what is known as a “lock-out,” or a period of time after an investment is made when a withdrawal is not allowed, and investors do not have access to their invested capital.
One downside of this structure is that if an alternative investment starts losing value, you might not be able to get out as soon as you’d like, and experience further losses. However, for investors who are willing to give up that liquidity and take on additional risk, alternative investments are expected to compensate them for that with a better potential return for the risk compared to traditional investments.
Other important alternative investment differences include market size and correlation to public markets. At a high level, take, for example, an alternative investment in professionally managed commercial real estate versus stocks and bonds. The public U.S. stock and U.S. bond markets are the largest in the world, with estimated values of $52 trillion and $49 trillion, respectively. However, professionally managed U.S. commercial real estate is no slouch, with an estimated value of $16 trillion.
This point is made because many individual investors have allocations to stocks or bonds (or other “safe” investments, such as bank deposits/CDs), but little to no holdings of CRE, which is almost 20% of the value of professionally managed assets in the U.S.!
One last and important difference to mention in this high-level blog is correlation, or how asset classes move together. Over very long time frames, CRE has only been 7% correlated to the U.S. stock market and negatively correlated to the U.S. bond market. Ultimately, this means that commercial real estate can add value through diversifying an investor’s portfolio to make it less volatile over the long run. Because it does not move in sync with stocks or bonds, it can provide a different source of returns than just being invested in traditional asset classes.
So, after finding out about the size and correlation of this one alternative asset class, you may be asking yourself if this is something to consider adding to your portfolio.
If you need your money to be accessible in the near future, alternative investments might not be for you. But suppose you have no urgent use for those funds and don’t mind having them tied up for a longer period of time. In that case, alternative investments can diversify your portfolio, produce potentially strong returns over the long run and experience less price volatility than traditional investments.
If you’re wondering whether you’d be a good candidate for alternative investments, our advisors at Heritage would be glad to discuss options with you. Give us a call at 877.887.8899 or contact us online to learn more.