Alternative Investments

Alternative investments are a group of investment options that can offer diversification benefits to those with sufficient resources and investment expertise. These investments have risk and return characteristics that differ from the regular asset classes. The goal is to reduce the correlation between the portfolio’s traditional equity and bond portions.

LEARNING OUTCOMES

At the end of this course, you will be able to understand:-

• Tangibles as investment vehicles.
• Important points that should be considered before investing in tangibles.
• Ways of investing in gold and other essential metals.
• Gemstones and collectibles and their importance as an investment vehicle.

What is an Alternative Investment?

Alternative investments, also known as “alternatives” or “alts,” are generally considered investments in asset classes other than stocks, bonds, and cash. There is a robust list of alternative investments, ranging from tangible assets like art and precious metals to financial assets like venture capital and real estate investments.

Alternative investments aren’t traded on public markets like stock exchanges or OTC. Instead, they’ve traditionally been invested through more exclusive channels like Portfolio Management Services and Alternative Investment Funds.

Because alternatives tend to have lower correlations to traditional investments, they are primarily used to diversify an investment portfolio and provide return profiles that may differ from those of conventional investments.

For large institutional investors with a tolerance for illiquidity, alternative investments could include a combination of hedge funds, private equity, alternative credit, and real estate. For individual investors, the alternative investment universe may consist of all of these and even vintage cars, rare wines, or fine art.

Types of Alternative Investments

Alternative investments are worth considering if you want to diversify your portfolio and achieve higher returns. However, alternative investments aren’t for everyone. Due to the diversity of investments available and the nuances and regulations associated with each, you must understand the market well before putting any money into it.

Types of alternative investments you might be interested in exploring:

Real Estate

Investing in commercial or residential real estate can be profitable as a short-term or long-term investment strategy. For example, you can purchase properties below market value, renovate and then sell these properties for an immediate profit or you can purchase rental properties and earn consistent monthly income from your tenants.

The downside is real estate investing generally requires a significant initial investment. You may get a bank loan to cover the purchase price, but you’re responsible for other costs associated with buying a property, like down payments and closing costs. Additionally, you’ll need cash to maintain and fix up properties you’re flipping or renting.

An alternative way to invest in real estate is through Real Estate Mutual Funds or Real Estate Investment Trust(REIT). It can reduce the amount you need to start investing. In addition, since real estate tends to appreciate over time, the equity you gain from buying and holding real estate can be a powerful asset.

Venture Capital

Venture capital is putting money into a small business or startup, which is felt to have great potential for growth in the long run. This investment strategy can occur at different stages of a business cycle. The first is investing in the early stages of companies with innovative business ideas with high growth potential, commonly referred to as angel investment.

The second is financing or investing in companies with proven business models with suitable customer bases and positive cash flows or profits, commonly referred to as growth equity. These companies have the opportunity to grow by adding new production facilities or through expansion, but they don’t generate sufficient cash flows from their operations to support their growth plans.

The other strategy is buyouts, which consist of financing established companies that require money to restructure and facilitate a change of ownership. Buyouts include making a public company private.

The last strategy is distressed investing, which involves investing in companies in financial distress. The capital is usually used to pay debt and restructure the company.

Private Equity

Private equity generally involves buying shares in companies that are not listed on a public exchange or purchasing shares of public companies to make them personal. Private equity can apply many strategies that may help provide money to companies at different stages of their development.

Private Debt

Private debt refers to investments not financed by banks (i.e., a bank loan) or traded on an open market. Both public and private companies can borrow via personal debt.

Private debt is leveraged when companies need additional capital to grow their businesses. The companies that issue the capital are called private debt funds, and they typically make money in two ways: through interest payments and the initial loan repayment.

Hedge Funds

If you’re a seasoned investor with plenty of cash, you can diversify your portfolio by investing in hedge funds. This investment strategy works similarly to a mutual fund in that you’ll pool your money with other investors to invest in securities and other instruments.

Hedge funds have a manager who oversees the fund and chooses the best investment strategy. Hedge funds have a more aggressive investment approach, which often means higher returns on your investment. Hedge funds are only for wealthy investors. This investment typically requires a minimum investment of 50 Lacs or more.

Structured Products

Structured products usually involve fixed income markets—those that pay investors dividend payments like government or corporate bonds—and derivatives, or securities whose value comes from an underlying asset or group of assets like stocks, bonds, or market indices. Examples of structured products include credit default swaps (CDS) and collateralized debt obligations (CDOs).

Structured products can be complex and sometimes risky investment products but offer investors a customized product mix to meet their individual needs. They’re most commonly created by investment banks and offered to hedge funds, organizations, or retail investors.

Commodities

Commodities are tangible assets that create consumer products like metals, crops, livestock, etc. “soft commodities,” such as cotton, sugar cane, and coffee, cannot be stored for long periods. Investors can buy and sell commodities directly on the stock market or via derivatives such as futures and options. Commodities are another tremendous alternative investment because they’re one of the few asset classes that benefit from inflation. Naturally, as commodity demand increases, so do their prices, which helps hedge against inflation.

Artwork and Collectibles

Artwork and collectibles are alternative investments that require much market knowledge and patience. Investing in artwork and collectibles correctly predicts if and how they might grow in value over time. Since it’s hard to judge demand and appeal 20-50 years down the line, this investment is a shot in the dark if you don’t know what you’re doing. Between counterfeiting and essential wear and tear, artwork and collectibles are very illiquid and likely to lose value, so if you invest, make sure what you’re buying is something you’ll cherish forever.

Gold and Precious Metals

Precious metals are tangibles that concentrate much value in a small amount of weight and volume. In other words, just a tiny piece of precious metal is worth a lot of money. Three kinds of precious metals command the most investor’s attention:

• Gold.
• Silver.
• Platinum.

Of these three, silver is the cheapest. It is far less expensive than either gold or platinum. Gold is by far the most popular precious metal; hence, it is discussed further in detail as an essential tangible.

Precious Metals

Gold

For thousands of years, people have been fascinated with gold. Records from the age of the pharaohs in Egypt expressed a desire to own gold. Today, ownership of gold is still regarded as a necessity by many investors, and its price has increased considerably since 1990.

Like other forms of precious metals, gold is a highly speculative investment vehicle whose price has fluctuated widely over the past twenty years. Many investors hold at least a part—and at times, a substantial part—of their portfolios in gold as a hedge against inflation or a world economic or political disaster.

Silver and Platinum

Gold, silver, and platinum can be bought in various forms. Silver can be purchased as:

• Silver Bars or Ingots
• Silver Coins
• Bags of silver coins.
• Shares of Silver-mining companies.
• Derivative Contracts like FUTURES and OPTIONS.

Similarly, platinum can be bought in the form of:

• Coins, plates, and ingots.
• Platinum-mining stocks, etc.

Transaction costs in precious metals vary widely, depending on the investment form chosen.

Different Ways of Gold Investment

Gold can be purchased as coins, bullion, or jewelry (all of which can be physically held). It can also be purchased through gold-mining stocks and mutual funds, ETFs, Gold Futures (and Options), and Gold Certificates. A brief rundown of the different ways gold can be held as a form of investing is listed below:

Bullion

Bullion is the general name for pure gold or silver (at least 99.5%) which have been transformed into bars or minted into coins for investment purposes. Examples of gold bullion include gold bard and gold numismatic coins.

Gold Bars and Coins

Gold bars and coins have little or no collector value; instead, their value is determined primarily by the quality and amount of gold in the bar and coins, as per the prevailing market value.

Gold Jewellery

Jewelry is a popular way to own gold. Still, it is not an excellent way to invest in gold because gold jewelry usually sells for a substantial premium over its underlying gold value (to reflect artisan costs, retail mark-ups, and other factors). Moreover, most jewelry is not pure 24-carat gold but a 14/18-carat blend of gold and other non-precious metals.

Gold Stocks, Mutual Funds, and Exchange-Traded Funds (ETFs)

Many investors prefer to purchase shares of gold-mining companies, mutual funds, or ETFs that invest in gold stocks. This is because the prices of gold-mining stocks tend to relate directly to the price of gold. Thus, when gold rises in value, these stocks also move up. It is also possible to purchase shares in mutual funds that invest primarily in gold-mining stocks. Gold funds offer professional management and a much higher level of portfolio diversification; the shares of gold-oriented mutual funds also tend to fluctuate along with the price of gold.

Gold Certificates

A convenient and safe way to own gold is to purchase a gold certificate through a bank or broker. The certificate represents ownership of a specific quantity of gold stored in a bank vault. In this way, you do not have to be concerned about the safety that taking physical possession of gold entails.

Gold Futures

Gold Futures refers to a deal in which an individual agrees to take delivery of the gold at a mutually decided upon date by making an initial payment, with the complete payment as per an agreement. This trade is based on speculation, with an element of risk involved.

Future is a derivative instrument, and investing in derivatives requires more knowledge of financial securities than other forms of investing and may not be suitable for all investors.

Gemstones

Gemstones consist of diamonds and the so-called colored precious stones (rubies, sapphires, and emeralds). Precious stones offer their owners beauty and are often purchased for aesthetic pleasure. However, diamonds and colored stones also serve as a viable form of investing.

Along with gold, they are among the oldest investment vehicles, providing a source of natural wealth and a hedge against political and economic uncertainties.

• Ruby.
• Sapphire.
• Emerald.
• Diamond.

Diamond Investment

Diamonds and colored stones are very much a specialist’s domain.

Generally, standards of value are fully appreciated only by experienced personnel at fine stores, dealers, cutters, and an occasional connoisseur collector. In diamonds, the value depends on the stone’s whiteness and crystallization purity. A key factor, therefore, is for the purchaser to understand the determinants of quality. As a result, precious stones vary enormously in price, depending on how close they come to gem color and purity.

Investment diamonds and colored stones can be purchased through registered gem dealers. Depending on quality and grade, commissions and dealer mark-ups can range from 20% to 100%. Because of the difficulty in valuing gemstones, selecting only dealers with impeccable reputations is imperative.

Precious Stones as an Alternative Investment

As investment vehicles, diamonds and colored stones offer no current income, but their prices are highly susceptible to changing market conditions.

The considerable difficulty in precious stone investments, aside from the expertise needed in deciding what gem quality is the relative illiquidity of the stones. As a rule, gemstones should be purchased only by investors who can hold them for at least years; high transaction costs usually mean that profitable resale is not possible after shorter periods. Furthermore, gemstones could be difficult to resell, and sellers often wait a month or more for sale. Diamonds and colored stones also require secure storage, and there are no payoffs before the sale.

Collectibles

Collectibles represent a broad range of items—from coins and stamps to posters and cars—desirable for many reasons, such as beauty, scarcity, historical significance, or age. In addition, collectibles have value because of their attractiveness to collectors.

Following are some examples of collectibles that have done well in recent years:

• Paintings.
• Vintage automobiles, etc.

An investment-grade collectible is an item that is relatively scarce as well as historically significant within the context of the collectible genre itself and, preferably, within the larger context of the culture that produced it. Further, it should be in excellent condition and attractive to display.

Categories of Collectibles

Although there are almost no bounds to what can be collected (beer cans, fishing tackle, magazines, sheet music)

The major types of collectibles that tend to offer the most significant investment potential include:

• Rare coins (numismatics)
• Rare stamps (philately)
• Artwork (the paintings, prints, sculptures, and crafts of recognized artists)
• Antiques (cars, furniture, etc.)
• Books.
• Games, toys, and comic books.
• Posters.
• Movie memorabilia.
• Historical letters.

Collectibles as Alternative Investment

In general, collectibles are not very liquid. Their resale market is poor, and transaction costs can be high. In investing, one is advised to become a knowledgeable collector before even attempting to be a serious investor in collectibles. Although certain psychic income may be realized in the form of aesthetic pleasure, the financial return, if any, is realized only when the item is sold.

On a strictly financial basis, items that have a good market and are likely to appreciate are the ones to collect. However, if an item under consideration is expensive, its value and authenticity should always be confirmed by an expert before purchase (There are many unscrupulous dealers in collectible items).

After purchase, you should make sure to store collectibles in a safe place and adequately insure them against all relevant perils. Despite these obstacles, collectibles can provide highly competitive rates of return and be good inflation hedges during periods of abnormally high inflation.

Key Features of Alternative Investments

Alternative investments cover a wide range of assets and strategies. Generally speaking; however, they are characterized by:

• Low correlation to traditional investments like stocks and bonds.
• Higher return potential than traditional investments.
• More esoteric and oftentimes illiquid assets.
• Longer lock-up of periods, meaning shares or interests may not be able to be redeemed/sold daily. This helps allow for exposure to less liquid assets.
• Often complex investment structures and risk-return profiles.
• Typically, higher minimum investment requirements.
• Unique risk profile that should be understood before investing.

Alternative Vs. Traditional Investments

Difference between Alternative and Traditional Investments

Alternative Investment Strategies

Not all investments were created equal. Different investments might provide different value to your portfolio. However, in general terms, you can think of alternative investments as falling into one of three categories:

Income

These are investments that give you a cash-on-cash return. An example of an income investment would be to purchase a franchise or interest-generating fund.

Growth

Investing in goods or commodities that do not produce income could have a significant price appreciation. An example of a growth investment might be art, fine wine, coins, or gold.

Balance

These investments provide both income and growth. An example of a balanced investment strategy might be to purchase a property that you then rent out to gain income from its growth because of home price appreciation.

Alternatives are not suitable for every investor; however, given their unique risk-return profile and complex investment characteristics, they are often most attractive and more suitable for more sophisticated and higher-net-worth investors.

In addition to meeting minimum investment and suitability requirements, investors should also consider their time horizon, investment objectives, and their ability to withstand periods of volatility before considering an allocation to alternatives.

Make the Right Choice

Investments such as stocks and bonds may not be very interesting or exciting, but as you can see, they have proven to be the most stable type of investment in the long run. On the other hand, investing in tangibles or alternative investments may seem attractive, but it may not be the best way to achieve your financial goals.

Wise planning is the best way to get the most out of your investments. First, research the types of investments available to make an informed decision. Next, weigh the advantages and disadvantages of each type of investment. Finally, ask yourself how much risk and responsibility you are willing to assume. With these steps, you can decide what is best for your financial future.