Alternative investments come in a variety of forms, from hedge funds and private equity to real estate and precious metals. What all these investments have in common is that they're designed to give investors a large amount of income from the money they put into them up-front. Alternative investments can include anything from actively managed mutual funds or ETFs to unlisted bonds and certificates of deposit (CD). Keep reading to learn more about how alternatives work.
What Are "Alternative Investments"?
Many people think of investing as buying securities, such as stocks and bonds, which pay dividends or interest on a regular basis. While this kind of investment is called a “traditional” investment, an alternative investment is better defined as one which offers an upfront payment with the potential for high returns in the future.
While these investments may have different structures and rules, they all have one thing in common: they're meant to give investors a large amount of income from their money up-front. Alternative investments are different from traditional ones because their payout comes in the form of high returns at the end instead of steady payments spread out over time.
By their very nature, alternative investments aren't liquid. Liquidity is how easily you can get your money out when you need it, such as if you need to buy a car or have some unexpected expenses pop up. Alternative investments reward long-term investors who are willing to delay their payout (via interest or dividends) for a much higher return than traditional ones.
Risks associated with alternative investments:
Before you dive into any alternative investments, it's important to be aware of some of the risks associated with them. Because these funds aren't traded on a stock exchange and instead have an odd structure that can delay payouts by months at a time, they're much riskier for investors. These are some of the main risks associated with alternative investments:
Volatile:
Alternative investments can be more volatile than traditional ones. This means that when you make a decision to sell a fund at a loss, you can get hit with more taxes or lose more money.
High risk-high return:
Many alternative investments come with high risk and relatively low returns. These assets can lead to sudden big payouts that are extremely difficult to predict or plan for.
No liquidity or high expense ratios:
Because these funds aren't traded on any stock exchange, it's very difficult for investors to sell them when they want or need to. This makes them riskier than traditional investments.
Taxes:
Alternative investments are often bought and sold as capital assets, which means they're taxed as if they were stocks or bonds owned for more than a year. If you buy an asset and sell it a few months later at a loss, the IRS will consider this a short-term “capital loss” (which carries special tax consequences). Investors who have held these assets for longer than 12 months get long-term capital gains treatment, but this is still unfavorable to most investors.
How Do Alternative Investments Work?
As we mentioned above, alternative investments aren't easily liquidated. These investments are frequently traded over a stock exchange, which makes them easier to buy and sell. But alternative investments aren't traded through a stock exchange, so they're much less liquid. This means that you can't sell them or get your money out just as quickly or easily as you could with a traditional investment.
One of the reasons investors are drawn to these types of funds is because they're designed to take a very little risk and give investors huge payouts—all at once. These funds use complex investment structures that spread out the payouts over months and offer investors high returns on their money. So how do these investments work?
Examples of Alternative Investments
Real estate funds are one example of an investment that produces high returns per individual fund but isn't liquid because it doesn't trade on a stock exchange. This can make it hard for investors to buy and sell these funds, but it also means that the fund manager can put more of your money to work in the properties rather than paying out your income.
Another example of an alternative investment structure is a master limited partnership (MLP). This is similar to a REIT, except that an MLP owns a partnership that has income from a business. In this case, the business makes money from something other than its own trading activity, such as natural resources (like oil or gas) or commodities markets. In return for investing in equity in the entity that owns the business, you get regular payments (a dividend) and partial ownership of the business.
The risk in MLPs is very low, however, because the partnership has a steady cash flow and most investors can get out of their investment fairly easily for a quick profit if necessary.
The Importance of Liquidity When Investing in Alternative Investments
One of the main risks associated with alternative investments is that they have high costs and are traded only over-the-counter (OTC), which means they aren't listed on any exchange like the New York Stock Exchange or American Stock Exchange. As you'll see below, if you want to invest in an alternative investment fund, your best bet is to go with a traditional financial advisor that offers access to alternative investments.
The lack of liquidity in these funds can be a serious problem. Because they’re traded OTC, the ability to sell your shares quickly if you need to is limited. The market for these funds is very small and most investors have no way of selling their shares after purchase.
When Is Alternative Investing a Good Choice for a Portfolio?
Alternative investments are generally considered best for those with longer time horizons, who are willing to wait for returns. Because these funds take more time to build up, they're good for investors with more patience. If your portfolio is made up of short-term investments like CDs or money market funds, then alternative investments aren't the best choice.
Because of their relatively high yields, investors who invest in alternative investment products can expect to make a good return on their investment over the long term—often double digits per year.
