What are “alternative investments?” To some investors, the term is synonymous with risk. Other investors see alternative investments as a special opportunity. Definitions vary depending on who you ask, but in this piece we’ll define alternative investments as assets or securities that don’t neatly fit into the more common asset classes like stocks, bonds and cash.
Alternative investments aren’t inherently good, bad, safe or risky. Each has its own set of potential risks and returns. Where most investors go wrong is by not understanding these investment alternatives and investing in them due to hype, fear, greed or some other emotional response.
Here we’ll mention a few alternative investments you may be familiar with. In Fisher Investments’ view, its imperative you learn as much as you can about an alternative investment and its risks before committing any of your hard-earned retirement funds to it.
Cryptocurrencies like Bitcoin (one of the most widely known cryptocurrency) have become increasingly popular alternative investments in recent years, causing some investors to consider adding cryptocurrency investments to their portfolios.
But, what is cryptocurrency (aka, “crypto”)? Put simply, cryptocurrencies are digital versions of cash. Individuals can buy and sell cryptocurrency investments on specific exchanges and transfer coin ownership from one digital “wallet” to another.
Proponents think cryptocurrencies—and their underlying platform called blockchain (a shared public ledger)—will revolutionize money by eliminating banks’ and governments’ involvement. The decentralized nature of cryptocurrency is why many crypto fans claim it’s the currency of the future. Because it is decentralized, they say that it’s more efficient than traditional currencies.
Despite having “currency” in its name, cryptocurrencies don’t act like traditional currencies. These investment alternatives are notoriously volatile. Widely used currencies don’t usually experience radical short-term volatility—they’re liquid, plentiful, stable and readily exchanged for goods and services. Hope, hype and fear drive large cryptocurrency price swings, making crypto very un-currency like. Put in proper perspective, bitcoin and other cryptocurrencies act more like speculative commodity investments.
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Volatility can severely inhibit investors’ ability to purchase goods and services with crypto. In order for any currency to be widely used as a medium of exchange, it needs stability. Using cryptocurrency to diversify how you spend money will likely mean dramatic fluctuations in your day-to-day purchasing power. Could you imagine relying solely on cryptocurrency when doing ordinary things like shopping for groceries or filling up your car with petrol?
Another cryptocurrency investment consideration is the fact that crypto faces global regulatory uncertainty. Governments have a long history of regulating financial markets, and several are cracking down on crypto trading. Traditionally, central banks control money in circulation. Influencing interest rates, printing money and setting bank reserve requirements are all tools central banks use to control the money supply.
For crypto investors, government interference would likely have negative effects on widespread cryptocurrency adoption efforts, keeping new crypto investors sidelined. Since cryptocurrencies are designed to operate outside government control, it’s no surprise governments around the world have started to crack down on crypto.
Investors who consider owning a stake in a cryptocurrency should have the right expectations and not get carried away. Putting too much into any investment, especially cryptocurrency investments, could harm your financial health.
Private equity is another investment alternative some consider for their portfolios. Private equity refers to investing directly in private companies that aren’t listed on a public exchange. Given their added complexity relative to stock and bond investments, private equity investments are usually marketed to institutions and high net worth investors. The most common way to invest in private equity is through a private equity fund, which pools investor assets and chooses companies to invest in.
Investors sometimes seek private equity funds because fund managers or advisers often boast outsized historical returns. However, past returns do not guarantee future results, and it’s important to understand how much risk an adviser might take to achieve high returns. Did they put all their eggs in one basket? If so, it may have elevated risk potential.
A potential issue of private equity funds is that they sometimes require investors to hold the investment for a minimum time period, sometimes locking up your money for years. This illiquidity means investors should be sure they have enough money to live on until the fund permits redemptions. If investors have family emergencies or medical issues requiring excess capital during that period, they could be in trouble until that holding period is up.
Another thing to consider with private equity is fees. Private equity funds often charge two layers of fees: A management fee—often 2% of assets under management—and a performance fee, which can be as high as 20% of investment profits. This standard private equity fee arrangement is called “2 and 20.” One can see how such fees could quickly eat into potential excess returns.
Real Estate Investment
There are two main types of real estate investments—direct and indirect. Examples of a direct real estate investment include leasing property or reselling it for a profit (e.g., “house flipping”). An indirect real estate investment example is buying shares in a real estate fund or other pooled-investment vehicle.
Owning physical property—a direct investment—can be labor-intensive and includes costs of regular maintenance and upkeep. For investors looking to avoid the hassles of owning actual property yet want real estate exposure in their portfolio, indirect real estate investment vehicles may be an option worth considering. One of the most common indirect real estate investment options is a real estate investment trust (REIT). REITs pool investor capital to purchase income-producing residential or commercial property.
Similar to private equity funds, REITs might include a pooled-asset structure, potential holding-period requirements and fees. Like any pooled-asset product, REITs are not personalized to investors’ individual goals and investors likely do not have much say in the underlying holdings. The illiquidity created from potential holding periods may span multiple years and may pose a problem to investors who need access to their funds in the interim.
Finally, REITs also come with their own set of fees. While they aren’t inherently higher or lower than those of other alternative investments, they may have higher upfront fees or sales commissions, which can reduce your initial investment amount. Like any investment, be sure to understand its fees before investing.
Broadly, the term commodity refers to a useful or valuable item. But in investing, commodities are most often raw materials like oil and gold or soft commodities like orange juice and pork bellies. Like all assets, commodity prices are driven by supply and demand. But unlike equities, they don’t have unlimited growth potential. Stocks have unlimited growth potential because companies are continually innovating, generating earnings and increasing their future earnings potential—productive assets.
Commodities, on the other hand, are static objects or materials—unproductive assets. For example, if you buy a bar of gold, at the end of 10 years you still just have a bar of gold. No cash flows. No additional fundamental value created through innovation and growth.
Consequently, commodities’ returns are based on whether the market for that commodity happens to be tighter—in terms of supply and demand—when you sell it than when you bought it. Less supply with static or higher demand means higher prices. And vice versa.
In order to successfully invest in these assets, you may need exceptional market-timing skills in order to profit. While investors tout some commodities as safe or some sort of market hedge, commodities can be very volatile and endure long periods of expansion and contraction.
Are Alternative Investments Right for You?
Some alternative investments may serve a purpose and add value for investors in certain situations. But for most long-term investors investing for retirement, traditional asset classes like stocks, bonds, ETFs and mutual funds are better tools.
Depending on the nature of the alternative asset, investors may face decreased investment flexibility, high fees, illiquidity, excessive volatility or other potential issues. People considering any of these investment alternatives for their retirement portfolio should do their own due diligence and understand all the terms, fees and nuances involved before considering these investment opportunities.
Investing in securities involves a risk of loss. Past performance is never a guarantee of future returns. Investing in foreign stock markets involves additional risks, such as the risk of currency fluctuations. The foregoing constitutes the general views of Fisher Investments and should not be regarded as personalized investment advice or a reflection of the performance of Fisher Investments or its clients. Nothing herein is intended to be a recommendation or a forecast of market conditions. Rather it is intended to illustrate a point. Current and future markets may differ significantly from those illustrated here. Not all past forecasts were, nor future forecasts may be, as accurate as those predicted herein.