While we often discuss the advantages and disadvantages of a few common asset classes—such as stocks, bonds and cash—a topic we delve into less often is alternative investments. The definition of an alternative investment can vary widely depending on who you ask, but in this article we’ll broadly use it to refer to a few asset and security types that don’t neatly fit into any of the more common asset classes mentioned above. Most alternative investments in this sense are not inherently good, bad, safe or risky investments. They are typically just other assets that come with their own sets of potential risks and returns. Where most people go wrong is by not understanding them and investing in them due to hype, fear, greed or some other emotional response.
Here we’ll introduce a few alternative investments and discuss their characteristics and their potential pitfalls.
Private equity refers to investing directly in private companies whose shares may not be available on a public exchange. 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.
High net worth investors sometimes seek out private equity funds because fund managers or advisers can 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 have taken on to achieve high returns. Did they put all their eggs in one basket? If so, it may have elevated risk potential.
A potential issue is that private equity funds might require investors to invest for a minimum time period, sometimes years. This illiquidity means investors should be sure they have enough funds to live off of 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 funds is their fees. Private equity funds may charge both a management fee—as a percentage of assets under management—along with an additional performance fee—charging them an additional percentage of their profits. Depending on the fees of any particular adviser or fund, these could eat into any potential excess return .
When investors discuss real estate investing, they normally aren’t considering directly purchasing buildings or homes—though some “house flippers” might. Real estate investing can be direct—leasing out property or attempting to resell it for a profit or indirect—buying shares in a real estate fund or other pooled-investment vehicle. Owning physical property can be labor intensive and includes the costs of regular maintenance and upkeep. For this reason, most folks interested in investing invest in real estate indirectly.
One of the most common indirect real estate investment vehicles is a real estate investment trust (REIT). REITs pools investor capital to purchase income-producing residential or commercial property. REITs must pay a large percentage of taxable income to shareholders in order to avoid paying taxes at the corporate level. REIT investors’ the pay taxes on these dividends at their marginal income tax rates.
Similar to private equity funds, REITs’ disadvantages might include their pooled-asset structure, potential holding-period requirements and fees. Like any pooled-asset product, the investment vehicle is 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 that 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 detract from 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. However, in investing, commodities are most often raw materials, such as oil, gold or soft commodities like cotton and orange juice. Like all assets, commodities’ prices are driven by supply and demand, but unlike stocks, they don’t have unlimited growth potential. Stocks are fundamentally a growth investment because the companies you own a slice of are continually innovating, generating earnings and increasing their future earnings potential.
Companies are 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’ll still just have a bar of gold, most likely the same size and shape. No cash flows. No additional fundamental value created through innovation and growth.
Consequently, commodities’ investment returns on 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. In order to successfully invest in these assets, you may need exceptional market-timing skills in order to trade them profitably. While people tout some commodities like gold as safe or some sort of market hedge, commodities can be very volatile and go through long periods of boom and bust. Precious metals can also bust for very long periods of time as miners take time to slow output and demand can be soft relative to supply for years.
Cryptocurrencies such as bitcoin aim to be a digital currency. Fans think cryptocurrencies—and their underlying accounting platform called blockchain—will revolutionize money by eliminating banks’ and governments’ involvement. Despite their name, cryptocurrencies aren’t really currencies. Hope, hype and fear drive cryptocurrency price swings, making them unstable—and very un-currency like. Real money is liquid, plentiful, stable and exchanged for goods and services anywhere. Put in proper perspective, bitcoin and other cryptocurrencies act less like investments and more like speculative commodities. For all the recent headlines, the high speculation doesn’t make them wise investments in our view.
Cryptocurrencies can endure radical short-term volatility, so trying to profit off of these tokens can be extremely risky. This extreme volatility can also be tricky if investors are trying to sell at a certain price or as soon as possible. Potential liquidity problems or other delays can make trading these securities at a specific price difficult.
Among cryptocurrencies’ other drawbacks is the fact that they also face regulatory uncertainty globally, with several governments cracking down on trading. If investors are considering owning any stake in a cryptocurrency, it’s important to have the right expectations and not get carried away. Putting too much into such a risky and speculative bet could harm your financial health.
Some alternative investments may serve a specific purpose and may add value for investors in certain situations. However, for most retail investors seeking meet their long-term financial goals and objectives, common asset classes like stocks, bonds and cash may be better tools to use. Depending on the nature of the alternative asset, investors may face decreased investment flexibility, high fees, illiquidity or other potential issues. People considering any of these alternative investments for their long-term investment portfolio should be sure sure to understand all the terms, fees and nuances involved beforehand.
Fisher Investments has been studying capital markets for over 35 years. Our extensive Research Department is constantly analyzing ongoing market trends and new developments. To learn more about Fisher Investments’ insights or our fundamental approach to investing, contact us at (888) 823-9566 or explore our educational investing guides today.
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.