Over the course of the next couple of months, I will take an in-depth look at alternative investments and the benefits, pitfalls and the role they play in asset allocations. In the first segment of the series, I take a closer look at the growing asset class, what types of investments make up alternatives and some key characteristics of each.

Financial advisors are tasked with trying to create “bullet proof” investment portfolios for their clients that can withstand deep bear markets while also capturing upside gains. This task is becoming increasingly more difficult as markets evolve and move quicker than ever. Recent market behavior and past crises have proved that financial advisors must look beyond the typical stocks and bonds to diversify their portfolios and potentially enhance returns.

Enter alternative investments.

Correlations between U.S. and foreign equities have increased, while correlations between stocks and bonds have also increased during times of distress. Portfolios that were traditionally considered diversified could not withstand the global reach of the Global Financial Crisis and protections failed when they were needed most. With that in mind, alternative investments have emerged as a compelling option for those seeking to reduce correlation with conventional markets and access unique opportunities.

Do you need help building diversified investment portfolios for the modern investment era? If so, Zephyr can help.

Alternative investments are becoming increasingly accessible to a broader range of investors through various vehicles including interval funds, tender offer funds, and publicly traded alternatives. The increased accessibility has made client communication and education vital. Additionally, successful navigation of this landscape requires careful consideration of investment vehicles, investment objectives, risk tolerance, liquidity needs, and time horizon.

In this blog, we will explore what alternative investments are, their types, and their defining features, providing a comprehensive understanding of this dynamic asset class.

What Exactly Are Alternative Investments?

Simply put, alternative investments are financial assets that don't fall into the conventional investment categories of stocks, bonds, or cash. Think of them as the "everything else" in the investment world. These investments often involve non-publicly traded assets, unique strategies, or specialized markets. They are typically earmarked for institutional investors, high-net-worth individuals, and sophisticated retail investors seeking diversification, higher returns, or protection against market volatility. However, innovation has made alternative investments increasingly accessible to a broader range of investors through various investment vehicles.

The primary appeal of alternative investments lies in their potential to generate returns that aren't directly tied to public market performance. This characteristic makes them valuable tools for portfolio diversification, risk management, and potentially achieving higher returns in certain market conditions.

Unlike traditional investments, alternative investments often have lower liquidity, higher risk, and require a longer investment horizon. However, they also offer unique opportunities to hedge against inflation, generate alpha, and access markets that are less correlated with public equities and bonds.

Types of Alternative Investments

The world of alternatives is vast and include a wide range of asset classes. Below are some of the characteristics and features of the most common types.

1.) Private Equity

Private equity involves investing in companies that aren't publicly traded on stock exchanges. Investors provide capital to private firms in exchange for equity ownership, often with the goal of improving the company’s operations and profitability before selling it at a higher valuation. These investments typically require substantial capital commitments for extended periods, often 7-10 years or longer.

Private equity encompasses several strategies:

• Venture Capital: Funding early-stage companies with high growth potential
• Growth Equity: Investing in established companies seeking expansion capital
• Buyouts: Acquiring controlling interests in mature companies, often with the intention of restructuring operations to increase value
• Distressed Investing: Purchasing troubled companies at discounted prices with the goal of turning them around

Private equity firms create value through operational improvements, strategic repositioning, financial engineering, and industry consolidation. While these investments can offer substantial returns, they require patience and tolerance for illiquidity.

2.) Hedge Funds

Hedge funds are actively managed investment pools that employ sophisticated strategies to generate returns regardless of market direction. Unlike mutual funds, hedge funds have fewer regulatory constraints, allowing them to use leverage, derivatives, short-selling, and other complex techniques.

Common hedge fund strategies include:

• Long/Short Equity: Combines long positions in undervalued stocks with short positions in overvalued ones.
• Global Macro: Making directional bets based on macroeconomic trends such as interest rates, currencies, and geopolitical events.
• Event-Driven: Capitalizing on corporate events like mergers, acquisitions, or bankruptcies
• Quantitative/Algorithmic: Using mathematical models and computer algorithms to identify trading opportunities
• Market Neutral: Seeking to eliminate market exposure through balanced long and short positions

Hedge funds are known for their flexibility and ability to adapt to changing market conditions, but they often come with high fees and require accredited investor status. These typically include performance fees (often 20% of profits) in addition to management fees (typically 1-2% of assets), following the traditional "2 and 20" model, though fee structures have become more competitive in recent years.

3.) Real Estate

Real estate investments involve purchasing physical properties or investing in real estate-focused funds. These investments can generate income through rental yields and capital appreciation. Real estate is probably the alternative investment most people are familiar with. Beyond just buying a home to live in, real estate investing can take many forms:

• Direct Property Ownership: Purchasing residential (single-family homes, apartments and condominiums), commercial (office buildings, retail spaces, and industrial properties)
• Real Estate Investment Trusts (REITs): Companies that own, operate, or finance income-producing real estate.
• Real Estate Funds: Private equity funds focused on real estate development or acquisition
• Real Estate Debt: Investing in mortgages or mortgage-backed securities

Real estate offers potential benefits including regular income streams, capital appreciation, tax advantages, and inflation protection. However, it also comes with challenges like property management responsibilities, market cyclicality, and liquidity constraints. Real estate is often considered a hedge against inflation, as property values and rental income tend to rise during inflationary periods.

4.) Private Credit

Private credit refers to non-bank lending to companies or individuals. Investors provide loans directly to borrowers, often in exchange for higher yields than traditional fixed-income securities.

Forms of Private Credit:

• Direct Lending: Providing loans directly to small and medium-sized companies
• Mezzanine Financing: Subordinated debt that sits between senior debt and equity
• Distressed Debt: Purchasing the debt of troubled companies at discounted prices
• Specialty Finance: Focused lending in areas like litigation finance, royalties, or asset-backed lending

Private debt typically offers higher yields than public fixed-income securities, making it attractive in low-interest-rate environments. Private credit is attractive for its predictable cash flows and relatively low correlation with public markets. The asset class has grown significantly following the 2008 financial crisis as banks reduced their lending activities due to increased regulation.

5.) Commodities

Commodity investments are physical goods that investors can gain exposure through futures contracts, ETFs, mutual funds or direct ownership.

Commodities include:

• Energy: Oil, natural gas, and renewable energy sources
• Precious Metals: Gold, silver, platinum, and palladium
• Agricultural Products: Grains, livestock, and soft commodities like coffee and sugar
• Industrial Metals: Copper, aluminum, and other metals used in manufacturing

Commodities often serve as inflation hedges and portfolio diversifiers due to their low correlation with traditional financial assets. Prices are influenced by supply and demand dynamics, geopolitical events, and macroeconomic trends.

6.) Infrastructure

Infrastructure investments involve funding large-scale projects such as transportation systems, utilities, renewable energy, and telecommunications. Infrastructure investments focus on essential physical systems that support economies, including:

• Transportation: Airports, toll roads, ports, and railways
• Utilities: Power generation, transmission, and distribution
• Communication: Cell towers, data centers, and fiber networks
• Social Infrastructure: Schools, hospitals, and government buildings

These investments typically offer stable, long-term cash flows, often with inflation protection through contractual arrangements. Infrastructure assets provide essential services with inelastic demand, making them relatively resilient during economic downturns.

7.) Collectables and Tangible Assets

Collectibles include art, antiques, rare coins, wine, and luxury goods. These investments are driven by scarcity, cultural value, and demand from wealthy collectors.

Key Features:

• Tangible assets often retain value during economic uncertainty.
• They can provide significant returns if demand increases over time.

Key Features of Alternative Investments

Diversification Benefits

Perhaps the most compelling feature of alternative investments is their potential to diversify traditional portfolios. Many alternative assets have low correlations with stocks and bonds, potentially reducing overall portfolio volatility and improving risk-adjusted returns.

Illiquidity Premium

Many alternative investments require longer holding periods, restricting investors' ability to quickly convert their holdings to cash. In exchange for accepting this illiquidity, investors often receive higher expected returns—a concept known as the "illiquidity premium."

Complexity

Alternative investments frequently involve complex structures, strategies, and terms. They may also operate with less transparency than public markets, making thorough due diligence essential before committing capital.

Higher Fees

Alternative investments typically carry higher fees than traditional investments. These may include management fees, performance fees, and various expenses related to the acquisition, management, and disposition of assets.

Access Requirements

Many alternative investments have high minimum investment thresholds and may be restricted to accredited or qualified investors who meet specific income or net worth requirements.

Potential for Higher Returns

Alternative investments can offer higher return potential compared to traditional assets, particularly in inefficient markets where skilled managers can identify mispriced opportunities.

Inflation Protection

Certain alternative assets, particularly real assets like real estate, infrastructure, and commodities, can provide natural hedges against inflation as their values and income streams often increase during inflationary periods.

Tax Considerations

Alternative investments may offer unique tax advantages, though they can also create complex tax situations requiring specialized expertise.

Active Management

Alternative investments often involve active management, where fund managers use their expertise to generate alpha. This contrasts with passive strategies commonly used in traditional investments.

Conclusion:

Whether you’re looking to help your clients hedge against inflation, capitalize on market inefficiencies, or explore new asset classes, alternative investments can play a vital role in achieving your client’s financial goals.

Alternative investments can add valuable diversification to your client’s investment portfolios, potentially enhancing returns and reducing overall risk. However, they come with their own challenges, including higher barriers to entry, less liquidity, and sometimes complex structures. As alternative investments go mainstream it’s becoming more important for financial advisors to understand the features, risks and opportunities associated with each sub type so they can effectively educate their clients on the different types.

As with any investment strategy, the key is finding the right balance for your client’s financial goals, risk tolerance, and time horizon. Alternative investments aren't for everyone, but for those willing to venture beyond the traditional, they offer intriguing possibilities to build wealth in ways that go beyond the ordinary.

Zephyr, is an award-winning asset and wealth management software that offers portfolio construction, proposal generation, advanced analytics, asset allocation, manager screening, risk analysis, portfolio performance and more, transforming multifaceted data into digestible intel.

Ryan Nauman is the Market Strategist at Zephyr, which helps investment professionals make more informed investment decisions on behalf of their clients.