Q. What are alternative investments?
A. Alternative investments are loosely defined as investments in assets other than traditional stocks and bonds. Hence the name. Generally, alternatives encompass a broad range of categories, including real estate, currencies, energy and commodities.
In recent years, the term “alternatives” has expanded to also include other sophisticated stock trading strategies, such as long-short funds that have the ability to “bet” against the market.
What’s the attraction?
For decades, large institutional investors and hedge funds have increasingly focused on asset classes with seemingly little to no correlation to the general stock and bond markets. In other words, investments that tend to “zig” when stocks and bonds “zag.” The idea has its roots in Modern Portfolio Theory, developed by Henry Markowitz in the 1950s and ultimately earning him a Nobel Prize in 1990. According to this theory, by adding riskier assets to a traditional stock and bond portfolio in the right proportion (that’s the trick), one potentially increases the overall portfolio return while decreasing risk. This proved a seductive, yet elusive, proposition as investors faced the “nowhere to hide” conundrum during the market crisis in 2008. However, over the long term the theory still holds water.
Another attraction is that many of these alternatives are either linked to or collateralized by hard assets such as real estate or commodities, which tend to keep pace with inflation.
What’s the risk?
A key risk is liquidity. While many alternatives offer dividends or interest over the holding period, it is not uncommon to have a one-year lock-up or in some programs as many as eight years before receiving a return of principal. In addition, alternatives can be every bit as volatile as the stock and bond markets, just at different times and in response to different economic indicators. Therefore, it is important that alternatives be considered only in light of a fully diversified portfolio.
Who is eligible?
Many of these strategies are available exclusively to accredited investors, defined as having a net worth of at least $1 million. The Dodd-Frank Financial Reform legislation, signed into law on July 21, now requires that an investor’s home equity on the primary residence be excluded from the $1 million equation. Still other programs accept investors with a minimum net worth of $250,000 or annual income greater than $70,000. While restrictive, these “net worth” and income requirements are in place to protect the average investor. Because alternative programs are illiquid, they generally are not appropriate for investors without significant other savings and assets to meet liquidity needs.
Alternative investments are not for everyone. Because of the special level of expertise required to understand and evaluate the various real estate, energy and commodity choices under the banner of “alternative investments,” it is important to seek advice from a trusted adviser who is qualified to help you determine whether they are appropriate for your situation.