“Alternative Investment”: What Is It?

When you hear the word “alternative investment,” you may think of a type of investment that is typically too complex for the ordinary investor to grasp, or one that is only available to large institutional investors. This is a widespread misperception that could have been somewhat accurate until recently. However, a far wider audience now has access to this type of assets due to recent regulatory reforms, and the advantages are significantly greater than you may anticipate. Investments in precious metals, oil and gas, venture capital, hedge funds, and real estate are all considered alternatives, or alts.

Read More: Fidelity alternative investment

Public and private investments are the two main groups into which all alternative investments may be divided. Real estate investment trusts, or REITs, are an alternative investment that you have probably heard of. This is a typical alternative investment for the public. They have most likely been discussed by your financial advisor, and it’s possible that your portfolio has some REIT assets. Furthermore, although REITs have their uses, private alternative investments offer many benefits that REITs do not. A lot of investors don’t know the difference. But private real estate funds do far better than REITs. We will focus on private alternative investments since we discover that they represent the largest gap in the majority of individuals’ portfolios.

So, Why Make an Initial Investment in the Alternative Asset Space?

There would be a significant discrepancy between the investment allocations of the large players and the typical individual investor.

Examine this data, which illustrates the differences in investing strategies between individuals and institutions (the large players).

Up to 30% of the portfolios of typical institutional investors, such as hedge funds, family offices, and endowments, contain assets other than stocks, bonds, and mutual funds. These investments can be made in hedge funds, real estate, and venture capital, among other things. This is in contrast to the typical individual investor, who allocates 95% of their funds to the stock market.

Even while the public market, which consists of stocks and bonds, is not inherently negative, institutional investors are aware of advantages that ordinary investors are unaware of.

This is yet another intriguing graphic that displays the Yale Endowment fund’s investment allocations. The fund in question is an intriguing case study since, some decades prior, Yale redirected funds from stocks and bonds to more nontraditional investments such as real estate, hedge funds, and even forestry. As a result, the endowment increased from $1.3 billion to $31.2 billion by 2020.

Throughout the previous couple decades, Yale has significantly beaten its domestic equities index, which is an index fund that invests in US companies. Over the last 20 years ending in July 2020, Yale achieved roughly a 10% annualized return. The return on the stock market during that period was 6.2%.

Why then aren’t normal investors following suit if the wealthiest and most successful investors are allocating a sizable portion of their portfolios to alternative investments and reaping greater returns?

Well, unless you had a prior relationship with the sponsors, individual investors didn’t have many choices outside of the public markets until 2012, when the Jobs Acts were approved. However, since this Act was passed, institutional investors with ties to private equity companies and larger family offices have been able to access private assets that were previously only available to accredited investors. Although institutional investors have been making long-term investments in this asset class, individual investors now have additional options to consider, some of which offer substantial upside potential.

Six Advantages of Investing in Alternatives

1. Typically Not Associated with the Stock Market

Anyone who has spent any amount of time investing in the stock market has probably made some significant gains as well as some significant losses. Anyone who is retired or about retired has had their portfolio decline, sometimes dramatically. It may be excruciating. One of the primary motivations for investors to look for alternative investments is diversification. Two of the best reasons to invest in alternatives are diversity and good returns, according to a new iCapital Network poll of leading U.S. financial advisers.

When an investment is uncorrelated with the stock market, it remains unchanged in relation to market fluctuations. Several investors mistakenly believe that holding REITS or other publicly listed alternatives can diversify their holdings; but, in reality, they are as volatile and don’t significantly increase the value of an investment portfolio.

2. Insufficient Volatility

The share price of a traditional public investment is typically unrelated to a real asset and is subject to a range of factors, many of which are not directly related to the success of the firm. You are spared the volatility of public investments when you make a private investment since the shares are not traded publicly. Furthermore, a genuine asset usually backs your investment.

Some people argue that long-term investors shouldn’t worry about volatility since, despite the stock market’s ups and downs, long-term returns still average between 6% and 8%. However, they fail to realize that compounding is killed by volatility. This is a circumstance that may cause you to reconsider.

3. Ownership Directly

Purchasing a paper asset, or the discounted worth of future projected revenues, is what most public investments entail. Actually, you own nothing. You’re still a long way from getting your name on the real estate property deed even if you invest in a REIT.

You immediately become the owner of the exquisite wine bottles or oil paintings that you purchase. You are the direct owner of the house if you purchased a rental property. You have a lien against real estate when you purchase a mortgage note. Alternatively, you usually have direct ownership of every asset that a private fund buys if you invest in one. Regarding Income Funds, each investor becomes a co-owner of a fund whose name appears on the mortgage title deeds it holds. Investors would still own the mortgage and have the right to use the property as collateral if we were to ever vanish.

4. Benefits from Direct Taxation

Additionally, there may be strong tax advantages from alternative investments. Due to their structure, many alternative investments allow you to keep a larger portion of your profit. You become a co-owner of the fund or syndicate in many private alternative investments, and as such, you immediately profit from the tax advantages.

Long-term capital gains treatment and pass-through depreciation are the two main tax advantages. Depreciation is a non-cash expenditure that is subtracted from net income by many real estate funds or syndications, which lowers taxable income. Investments in oil and gas enjoy extremely advantageous depreciation and depletion tax treatment.

5. Robust Income

Though many do, usually as part of a cash-flowing real estate plan, not all private alternative investments are cash-flowing, meaning they don’t pay you back in cash on a monthly or quarterly basis. A robust income in the 8–10% range can be generated by some. A lot of funds are set up with a preferred return, which pays investors in cash initially.

It’s no secret how challenging it can be to make money from public investments like CDs, bonds, and dividend-paying equities. We frequently speak with clients who are having trouble producing cash flow—typically in the low single digits—in their portfolios. The public markets, as was previously said, can be quite volatile, raising the risk in order to produce a little return.

6. Investments in Passivity

Time is something that most busy investors highly value, yet actively maintaining an asset or portfolio takes a ton of work. Since most investors believe that real estate is the best place to begin actively investing, let’s use it as an example. They first become enthusiastic about the idea of renting out a single-family house or even a modest multifamily apartment, but they soon come to understand how much effort and how steep the learning curve is. Numerous instructors are offering their “5 Step Plan to Success,” but in the end, it comes down to hard work: locating co-investors, securing funding, arranging the transaction, identifying and assessing properties, etc. Many investors abandon up at this stage, assuming there are no other possibilities.