Alternative Investments: A Complete Guide

What Are Alternative Investments?

Alternative investments are financial assets that fall outside of cash, stocks, or bonds. They are still regulated by the U.S. Securities and Exchange Commission (SEC), but less dependent on market conditions compared to other types of assets. Some examples include private equity, real estate, private debt, private mortgage loans, commodities, and venture capital.

Types of Alternative Investments

Private Equity

Capital investments in this category are explicitly private, with no public exchanges. Private equity encompasses venture capital, growth capital, and leveraged buyouts.

Private Debt

Private debt is debt financing provided by non-bank lenders to privately held companies, typically in the form of loans or bonds. Private debt can provide an alternative source of funding for companies instead of traditional bank loans or capital markets. Private debt investments are not traded on the open market. Private debt capital is made through repayments of the initial loan and interest payments.

Direct Real Estate

Property owners have cash flow and equity, with the end goal of capital appreciation. Some of the most important aspects to real estate investing are valuation methods, such as sales comparable.

Indirect Real Estate

Private Mortgage Loans

Private mortgage loans are used to provide financing for a wide range of real estate and infrastructure projects. Common forms of Private Mortgage Loans include Commercial Mortgage Loans (CMLs) and Residential Mortgage Loans (RMLs).

Commercial Mortgage Loans (CMLs)

Commercial mortgage loans are loans that are used to finance the purchase, construction, or improvement of commercial real estate properties, such as office buildings, retail centers, and industrial facilities. These loans are secured by a mortgage and repaid over a period of years. They are generally larger in size and based on the income -generating potential of the property.

Residential Mortgage Loans (CMLs)

Residential mortgage loans are loans that are used to finance the purchase or refinance of residential properties, such as single-family homes, condominiums, and townhouses. These loans are typically secured by a first mortgage on the underlying property and are repaid over a period of years.

REITS

There are two types of REITs, or Real Estate Investment Trusts. Equity REITs are investment vehicles that own and manage income-generating real estate properties, such as shopping centers, office buildings, apartments, hotels, and warehouses. They generate income for investors through the rent and lease payments collected from their properties. Mortgage REITs, or mREITs, purchase or originate mortgages and MBS earning fixed income from interest on those investments. mREITs fund these investments with equity and debt capital. REITs can be bought and sold like stocks, and they offer investors the potential for capital appreciation as well as regular income in the form of dividends.

Hedge Funds

The goal of hedge funds is to earn a high investment return – often targeting high net worth institutional investors such as mutual funds, pension funds, and endowments. Liquid assets are strategically traded depending on investor goals such as volatility arbitrage and long-short equity.

Commodities

Often, natural resource commodities rise and fall with the economy and the current state of supply and demand. Commodities are one of the oldest investments around – including agricultural products, oil, metal, and natural gas.

Collectibles

Collectibles include a wide range of products, from baseball cards to fine art, that investors hope will gain value over time. When investing in collectibles, it is important to understand the risks involved, such as resources needed to care for the items for long periods of time.

Structured Products

Fixed income markets revolve around structured products, such as mortgage-backed securities (MBS), collateralized debt obligations (CDO), and credit default swaps (CDS). These structured products are often more complex and higher risk but provide investor customization through features like rainbow notes and lookbacks. Investment banks sell structured products to retail investors, organizations, and hedge funds.

Benefits and Risks of Alternative Investments  

Benefits of Alternative Investments  

Investing in private markets offers several advantages for investors looking to diversify their portfolios and potentially enhance returns. Unlike public markets, private markets can offer higher returns due to their illiquid nature and the ability to capitalize on market inefficiencies. For sophisticated investors, alternative investments also provide access to opportunities outside the public markets, thus potentially capturing returns that are not correlated with traditional market indices. 

The floating rate nature of certain private credit investments ensures that the spread over benchmark rates can remain attractive even in uncertain economic environments. Additionally, private market asset valuations have been generally lower and less dispersed than those in public markets, which helps boost investor demand. Investors may also be drawn to the increased potential for capturing gains from private companies, especially with increased technology adoption and companies staying private longer. 

Risks of Alternative Investments 

Along with the potential benefits, alternative investments carry certain risks. Investing in private markets requires due diligence, as the success of such investments relies heavily on the fund manager’s expertise and the quality of the underlying assets. Additionally, alternatives often require longer investment horizons and feature higher minimum investments and fee structures compared to traditional investments. Illiquidity is another concern, as investors cannot easily redeem or sell these investments without a significant markdown in value or a potentially lengthy waiting period. Transparency and regulatory oversight loom large over alternative investments, adding further pressure and scrutiny to diligence considerations. 

Finally, the success of alternative investments can be dependent on the fund manager’s expertise and the quality of the underlying assets. As such, due diligence, strong analytical capabilities, and ongoing monitoring are critical when incorporating alternative investments into one’s portfolio. 

Why Invest in Alternative Investments?

Private markets and alternative investments offer portfolio diversification from standard asset classes such as bonds and cash and are affected by different factors than traditional assets. Alternatives also help manage risk by exposing portfolios to different risk factors, mitigating too much exposure to any one particular risk.

Are Alternative Investments a Good Idea?

Depending on investment goals, alternative investments can be a good idea for portfolio diversification and yield. Since alternative investments are dependent on private markets and don’t follow typical market trends, there is often high risk, but also potential for high returns.

Reasons to Invest in Alternative Investments

One of the biggest reasons to invest in alternative assets is portfolio diversification, since alternatives provide options that are not available in the public markets.  With real estate as an example, alternatives are still affected by the market with economic downturns and inflation. Although other investments such as property, gold, and oil tend to stay more consistent against inflation than traditional assets.

The Future of Alternative Investments  

The future of alternative investments appears robust, fueled by solid growth in private equity and venture capital. According to the latest Clearwater Analytics survey, investor sentiment is increasingly positive about alternative investments, with 55% expecting to increase their allocations within the next five years, while only 6% anticipate a decrease. North America is becoming the epicenter of the hedge fund industry, holding a dominant share (81% according to Preqin) of global AUM. In private wealth, advisors are facing challenges in helping clients gain exposure due to limitations like high investment minimums and illiquidity, although technological advancements are mitigating these barriers.  

Private debt strategies, particularly direct lending, have risen in popularity as banking regulations grow tighter, offering investors a desirable risk-return trade-off. Furthermore, the Inflation Reduction Act of 2022 in the U.S. is fostering significant investment in clean technology. The act is bolstering infrastructure investments, particularly in renewable energy, signaling strong growth prospects in that sector. Overall, with a diversified approach and strategic planning, alternative investments are well-positioned to play an increasingly vital role in sophisticated portfolios over the coming years. 

Common Mistakes in Alternative Investments  

Know who you are dealing with 

Navigating alternative investments requires careful consideration to avoid missteps. One common mistake investors make is not performing due diligence on the fund managers or firms they engage with, jeopardizing their capital with potentially untrustworthy or underqualified management.  

Risks and security  

Due to the opaque nature of alternative investments, assessing risks and ensuring security is paramount. Investors often underestimate market, liquidity, and credit risks, which can lead to significant losses.  

Fees and conflicts  

Fee structures and potential conflicts of interest also present pitfalls. High fees can erode returns, and undisclosed conflicts may lead to decisions that aren’t in the best interest of the investor.  

Extensions, maturities, and exits 

Additionally, understanding the terms of investments, such as extensions, maturities, and exits, is vital. With illiquid assets, the inability to exit a position when desired or unexpected extensions can impact portfolio performance and strategic planning. Investors should be acutely aware of the terms governing their investment to align their expectations with the realities of these complex vehicles. 

What Is The Best Alternative Investment?

The best alternative investment aligns with investor goals and strategies. For some, the best alternative investment could be real estate, for others, it could be cryptocurrency. Resources such as time and money are important factors in determining what alternative investments are most suitable to investors.

What Is An Example Of An Alternative Investment

Examples of alternative investments might include infrastructure, lending, private businesses, and cryptocurrency.

Regulation of Alternative Investments

There is less regulation of alternative investments than traditional investments. Alternative investments are required to be regulated by the SEC, but securities do not have to be registered.

Alternative Investment Software

Clearwater Analytics provides Alternative Investment Software that gives accounting and finance teams the advantage of automated data collection, reconciliation, accounting, performance, risk, and exposure reporting for alternative asset classes.  

To learn about Clearwater’s solution for alternative investments, schedule a meeting to speak to one of our experts.