What are Alternative Instruments?

TL;DR

• Investments that don’t qualify as a traditional long-only investment like a stock.
• Private Equity, Venture Capital, Real Estate, Hedge Funds are all examples of alternative investments

What are alternative investments?

Alternative investments differ from traditional investments by offering investors exposure to streams of return that go beyond traditional “long-only” market exposure.

Alternative investments offer low correlation to traditional investments, providing portfolios with a great source of diversification.

Real estate and antique investments are also classified as alternative investments.

Most alternative instruments are held by large institutions or high-net individual investors who can understand the complexity and risk involved. The reasons for this complexity are that alternative investments are not registered under the SEC or regulated under the Dodd-Frank act.

Hence, investors must conduct their own due diligence before investing in this field. In terms of risk, the initial investment for such assets is much higher than traditional investments and therefore the potential for loss is also higher. As a result, alternative investments are primarily issued to investors who can bear such high risk (net worth higher than $1 million).

Types of Alternative Investments

As mentioned above, alternative investments encompass assets that go against traditional long-only investments. This includes: hedge funds, venture capital, private equity, real estate, commodities, and even antiques. Usually these strategies are expressed via funds which are actively managed, carrying higher fees overall.

To provide one example of alternative strategy, look at so-called “equity long-short” hedge funds. These managers are able to bet on the rise of an asset’s price, as much as on it’s fall. By doing this, they are hedging their position against opposite movement in the price of an asset.

For another example, Venture Capital, which involves investing in early stage companies, pre-profit or -revenue, in hopes of getting a high return on investment as these companies grow explosively.

Both these strategies involve risk and a higher level of understanding, before any investment decisions can be made.

Benefits and Drawbacks

The primary benefits of investing in alternative investments are lack of correlation to traditional investments, protection against inflation and potential for high returns.

Since alternative investments move (or should move) with low correlation to the stock or bond market, they provide a good source of portfolio and return diversification. In specific cases like hard commodity assets like gold or real estate, investors also get a hedge against inflation. Lastly, these assets come with a lot of risk in terms of initial investment and liquidity.

The amount of money required by funds to invest in alternative investments is high (the investor must earn at least $200,00 a year). On top of this, alternative investments are very illiquid, making it tough for investors to exit an alternative investment position. For example, it’s more difficult to sell an antique vase than some shares of Amazon. However, with so much risk, investors are compensated with a much higher return and fees are also lower since fewer transactions take place.

Essentially, these investments can only be directly invested in by institutional investors and high net worth individuals because of its unregulated, complex and risky nature. If you, a retail investor, are interested in alternative investments, you can invest in them through alternative mutual funds and ETFs. E.g. ProShares UltraPro Short ETF trades on the Nasdaq (SQQQ), which is a 3x inverse leveraged ETF covering nonfinancial stocks. The ETF produces returns when the Nasdaq falls and amplifies the return by 3x. If the Nasdaq rises, the holder would face 3x the loss. This is what leverage implies.