Zero to Hero: Your Essential Guide to Alternative Investing as a Beginner

Alternative investments refer to asset classes and financial instruments that fall outside the conventional categories of stocks, bonds, and cash. They are considered alternatives to the traditional securities portfolios constructed via stocks and investment-grade bonds.

As interest grows for diversification beyond mainstream assets, alternative investments are attracting attention from investors wanting further portfolio allocation and risk mitigation strategies. However, these non-traditional assets have complexities requiring extensive due diligence.

This definitive guide provides an in-depth overview of alternative investments tailored for beginners.

Key Takeaways

• Alternative investments include private equity, hedge funds, real estate, commodities, fine art, and cryptocurrencies.
• They offer portfolio diversification but carry higher fees, illiquidity, risk, and barriers to entry.
• Investors must weigh added portfolio value against complexity, lack of transparency, and liquidity constraints.
• Extensive due diligence is vital before allocating capital to alternatives like private equity or collectibles.
• Some options like REITs and precious metal ETFs offer easier access to real estate and commodities exposure.

Types of Alternative Investments

Alternative investments span a wide variety of asset classes, each with distinct qualities and risk profiles.

Table 1: Alternative Investment Asset Class Correlation to Stocks (S&P 500)

Asset Class	10-Year Correlation
Private Equity	0.70
Venture Capital	0.55
Hedge Funds	0.80
Commodities	0.35
Real Estate	0.60
Gold	-0.05
Art & Collectibles	0.15
Peer-to-Peer Lending	0.30

This table demonstrates the 10-year correlation coefficients between various alternative investment asset classes and the general stock market as represented by the S&P 500 index. A lower correlation indicates an asset moves more independently from wider market swings.

Private Equity and Venture Capital

• Private equity firms invest directly in private companies or engage in buyouts of public firms, restructuring them outside the scrutiny of public markets.
• Venture capital firms focus on startups and early-stage companies with strong growth potential.
• Investments carry higher risk but can generate outsized returns compared to public markets.

Hedge Funds and Managed Futures

• Hedge funds use alternative strategies like short selling and arbitrage, aiming to generate gains under diverse market conditions.
• Managed futures funds trade futures contracts in areas like currencies, interest rates, agricultural commodities, or metals.

Real Estate

• Investing in real estate as an asset class can provide steady cash flow, profit potential from property appreciation, and a hedge against inflation.
• Investors can gain exposure via actual property ownership, real estate companies, REITs, or real estate private equity.

Commodities

• Commodities like agricultural goods, natural resources, and precious metals often move differently than equities and bonds.
• Commodities futures contracts and ETFs offer liquid access to indexes tracking commodity prices.

Farmland

• Farmland has delivered stable, steady returns uncorrelated to paper assets by producing essential commodities for growing populations.
• Investing in farmland often requires high capital commitments not accessible to many individual investors.

Art and Collectibles

• Art, fine wine, antique cars, and other collectibles let investors diversify into “passion assets” they appreciate.
• Difficulty establishing provenance and assessing fair value pose due diligence challenges.

Cryptocurrencies

• Cryptocurrencies like Bitcoin and Ethereum have gained adoption for sending payments and as speculative investments.
• Extreme volatility necessitates caution before allocating significant portfolio percentages.

Peer-to-Peer Lending

• Peer-to-peer loans connect individual borrowers with individual investors in fixed-income instruments outside traditional lenders.
• Interest rates vary widely depending on borrower creditworthiness.

Characteristics of Alternative Investments

While specifics differ vastly across alternative assets, they share some commonalities around regulation, liquidity, transparency, and barriers to entry.

Less Regulation from SEC

• Many alternative investments have been structured to avoid SEC registration which requires regular disclosures.
• This gives firms more flexibility in strategies but with less oversight.

Complex Nature and Higher Risk

• The complexity in alternatives like hedge funds and derivatives creates a lack of transparency.
• Understanding how they generate returns and associated risks requires extensive expertise.

Illiquidity and Difficult Valuation

• Alternatives often come with liquidity constraints from lock-up periods to withdrawal limitations. Trying to sell art or property can take months.
• Hard-to-value assets mean determining a fair price is challenging.

High Investment Minimums and Fees

• Many alternatives like private equity or venture capital have high minimum investments, often hundreds of thousands of dollars.
• Management fees, performance fees, and early withdrawal penalties need consideration.

Type of Alternative Investment	Typical Minimum Investment	Average Annual Fees
Private Equity Fund	$250,000+	2% + 20% of returns
Hedge Fund	$100,000+	2% + 20% of returns
Venture Capital Fund	$50,000+	3% + 30% of returns
Farmland LP	$25,000+	~1-2%
REIT	$1,000+	0.5-1%
Rental Real Estate	$50,000+	5-20% of rent
Art Fund	$10,000+	1-2% + 10% of returns
Gold/Precious Metals	Flexible	0.75%+
Cryptocurrency	Flexible	1-2%+

Table 2: Typical investment minimums and annual fee ranges among alternative asset classes

Benefits of Alternative Investments

Alternative investments appeal to investors for portfolio enhancement, higher returns, and inflation hedging.

Diversification from Mainstream Assets

• Alternative investments show a low correlation to stocks and bonds, meaning they can zag when markets zag.
• Adding a small allocation to alternatives can improve risk-adjusted returns.

Potential for Higher Returns

• For skilled managers, less regulation unlocks flexibility to pursue higher returns not achievable in public markets.
• Startup investments can multiply a hundredfold for high-growth venture capital funds.

Inflation Hedge

• Real assets like real estate, farmland, and commodities often maintain their intrinsic value better than stocks or bonds during inflationary periods.

Move Independently from Stocks and Bonds

• Alternatives like managed futures trading look at interest rates and currencies, not just company and market outlooks.
• This divergence provides some insulation from downturns in the capital markets.

Risks to Understand Before Investing

While alternatives offer portfolio diversification, they carry asset-specific and general risks to weigh carefully.

Less Liquidity

• Alternative investments often have “lock-up periods” ranging from 1-10 years, preventing investors from withdrawing capital.
• Trying to sell physical assets like property or artwork could take months or years.

Limited Regulation

• With relaxed disclosure standards, investors have less visibility into holdings and practices.
• This creates greater dependency on fund governance and integrity.

High Costs and Fees

• Alternative investment vehicles carry multiple layers of substantial fees, from management fees to performance fees.
• Investors need reasonable expectations for benchmark-beating returns to overcome higher expenses.

Steep Learning Curve

• The complexity around alternatives necessitates a commitment to developing knowledge of unfamiliar assets and strategies.
• Most investors underestimate the continuous education required.

Lack of Transparency

• Alternatives disclose far less information on positions, operations, and practices than registered securities.
• This asymmetry means determining fair value for underlying assets proves extremely difficult.

Regulation Around Alternatives

While definitions vary globally, most regulators classify alternatives separately from mainstream public market securities, leading to distinct regulatory standards.

Dodd-Frank Wall Street Reform Act

Passed during the 2009 financial crisis aftermath, the Dodd-Frank Act in the U.S. enacted greater oversight around derivatives trading and systematically important institutions using alternative investment strategies.

SEC Oversight and Examination

The SEC maintains a dedicated Office of Compliance Inspections and Examinations (OCIE) conducting routine and specialized examinations of advisers relying on registration exemptions, like private equity fund managers.

Accredited Investors and Legal Structures

Many alternatives limit participation to “accredited investors” who meet SEC wealth or income criteria. Most issue securities using legal structures like limited partnerships avoiding public registration.

Advantages and Disadvantages

Weighing the pros and cons of alternatives aids in determining if and how they fit into investment goals and constraints.

Pros

Portfolio Diversification

Alternative investments tend to demonstrate low correlations with traditional securities, allowing investors to enhance diversification. Adding alternatives may dampen volatility without sacrificing returns.

Higher Return Potential

Skilled alternative investment managers accessing private deal flow can generate sizable risk-adjusted returns exceeding commonly available assets. But past performance offers little guarantee of future success.

Inflation Hedge

Real assets with intrinsic value like real estate, farmland, and commodities hold value better than paper assets during inflationary periods. They offer a means to preserve purchasing power as currency gets devalued.

Here is the continuation of the alternative investments article:

Cons

Higher Fees and Costs

Alternative investments come with layers of fees – including management fees, performance fees, early withdrawal fees, and ongoing administrative costs – that can substantially erode net returns. Investors must model projected returns at multiple fee levels to set realistic targets.

Heightened Risk Levels

While alternatives pursue differentiated strategies, the use of leverage, derivatives, and concentration of positions can dramatically multiply risk. Volatility tolerance and risk parameters need alignment.

Limited Transparency

Unlike public securities filing detailed regular disclosures, alternatives have relaxed reporting requirements, disclosing little on positions, valuations, and operations. This lack of transparency relies heavily on fund governance and integrity.

Getting Started with Asset Classes

Investors curious about alternatives have various options to gain introductory exposure to specific asset classes.

Table 3: Sample Alternative Investment Allocation Evolution

Investor Profile	Beginner Portfolio	Intermediate Portfolio	Advanced Portfolio
Investment Assets	$50,000	$250,000	$1,000,000+
Alternatives Target Allocation	10%	20%	30-50%
Private Equity/Venture Capital	0%	5%	10-20%
Hedge Funds	0%	5%	10-20%
Real Estate	5%	10%	10-15%
Commodities Futures	0%	3%	5-10%
Cryptocurrencies	3%	5%	3-5%
Art & Collectibles	2%	2%	1-5%

As investors accumulate more investment capital and expand alternative investment expertise, allocations may shift across various asset types at different stages while increasing alternatives exposure overall.

Real Estate

Novice real estate investors may prefer more accessible avenues like REITs and real estate crowdfunding instead of direct property ownership.

REITs

Real estate investment trusts allow investors to gain exposure to portfolios of property assets like offices, hotels, storage facilities, and mortgages. REITs offer liquidity, professional management, stable dividends, and diversity across regions and sectors. Investors can access REITs via ETFs and mutual funds.

Real Estate Crowdfunding

Online crowdfunding platforms enable investors to pool capital towards specific properties or real estate projects normally unavailable to retail investors. By backing experienced operators and taking an ownership piece, investors participate in cash flow and appreciation.

Gold and Precious Metals

Those seeking inflation hedges via precious metals have options not requiring actual physical ownership.

Gold/Silver ETFs

ETFs tracking gold and silver prices offer a low-cost, liquid means of gaining exposure without storage hassles. Ownership represents fractional claims on underlying bullion stored by custodian banks. Changes in precious metal spot prices show in ETF values.

Mining Stocks

Publicly traded mining companies provide leveraged exposure to movements in commodity prices. However, risk factors specific to each mining operator contribute significant volatility above just gold/silver prices.

Cryptocurrency

While over 19,000 cryptocurrencies trade on global exchanges, Bitcoin and Ethereum represent nearly 60% of the total crypto market capitalization due to wider mainstream adoption.

Bitcoin

Known for its capped supply of 21 million and decentralized operation, Bitcoin enables fast digital payments and serves as the first widely adopted digital store of value. It carries high risk but high return potential.

Ethereum

Beyond digital currency uses, Ethereum’s functionality for smart contracts, decentralized applications and tokenization underlies many new blockchain innovations. It carries high-risk/high-reward characteristics similar to Bitcoin.

Crypto Investing Apps

User-friendly mobile apps like Coinbase and Gemini simplify the buying, selling, holding, staking, and safekeeping of cryptocurrencies with far lower barriers to entry than alternatives like IPO shares and rental properties requiring large upfront commitments. Low fees and educational resources accommodate first-time investors.

Industry Growth Projections

Surging interest from investors and wealth managers continues expanding the scope of the alternative investments universe at a heady pace.

• Over the next five years, global alternative assets under management should top $17 trillion across the institutional and retail markets, according to Preqin data, more than doubling 2020 levels.
• Private capital fundraising achieved records in 2021, attracting $1.2 trillion in fresh capital based on McKinsey research.
• total cryptocurrency market capitalization sits near $1 trillion as of Q1 2023, cementing prominence as an emerging alternative asset class.

Accelerating the adoption of alternatives calls for heightened diligence in evaluating the suitability of personalized portfolios.

Building an Alternatives Starter Portfolio

Investors asking “How much should I allocate to alternatives?” must assess individual risk constraints, return objectives, and knowledge limitations.

Typical starter portfolios stay conservatively positioned as investors expand their expertise. Sample allocations for beginner portfolios of $5,000 and $10,000:

Alternative Asset Category	Profile	Sample $5K allocation	Sample $10K allocation
Cryptocurrency	High-risk/high reward	30% BTC, 20% ETH	20% BTC, 10% ETH
Gold	Inflation hedge	15% gold ETF	10% gold miners ETF
REITs	Income/diversification	20% REIT ETF	15% REIT ETF
Real Estate Crowdfunding	Cash flow/appreciation	5% multifamily property	10% mixed-use development
Art/Collectible Fund	Passion asset	5% mid-tier art	5% vintage car fund
Peer-to-Peer Lending	Fixed income	5% 3-year notes	5% 3-year notes
Cash	Stability buffer	~10%	~15%

Table 4: Sample starter portfolio allocations for beginner alternative investors

Diversifying across 7-8 alternatives with small position sizes allows asset familiarization before potentially expanding stakes. Periodic rebalancing realigns allocations to original targets as performance diverges across holdings.

Investing in Top Alternative Asset Classes

Gaining tactical exposure to alternatives requires selecting investment vehicles suitable to risk tolerance and liquidity needs. Each asset class carries different options.

Private Equity

Wealthy individuals invest in private equity funds via direct private placements while accredited investors can access PE exposure through feeder funds pooling capital or via equity crowdfunding platforms like SeedInvest and WeFunder.

Real Estate

Beyond direct property ownership, real estate investing opens avenues like crowdfunding for pooled fractional ownership, publicly-traded REITs, real estate-focused ETFs, and mutual funds. Targeted options like farmland REITs or senior housing demonstrate further specialization.

Hedge Funds

To invest in traditional hedge fund strategies pursuing absolute returns across market environments, accredited individuals can subscribe to domestic and offshore hedge fund offerings, though many now have initial investment minimums of $1 million or more.

Commodities

Gaining futures-based exposure to broad commodity indexes requires opening a brokerage futures account to trade contracts on crude oil, agriculture goods, precious metals, and more. Retail investors can more easily access commodities through publicly traded commodity producers, royalty trusts, commodity ETFs, and emerging Crypto asset class custody platforms.

Art and Collectibles

Fractionalized ownership opportunities in collectible asset classes like fine art, wine, musical instruments, and rare artifacts come via specialized investment funds available to qualified clients. Unique physical pieces are traded privately or via auction houses.

Cryptocurrency

Buying, selling, and holding Bitcoin, Ethereum, and other digital currencies is readily accessible 24/7 via user-friendly crypto exchange apps like Coinbase and Gemini or dedicated wallet applications allowing self-custody, staking, governance rights, and layered DeFi application opportunities.

Always evaluate fee structures and account minimums before investing. For substantial positions in complex alternatives like hedge funds or private equity, professional advisory services assist in due diligence and taxation considerations.

Tax Rules Around Alternatives

Many alternatives come with specific tax implications investors evaluate before committing capital because tax liabilities can subtract heavily from net returns.

Private Equity and Hedge Fund Taxation

Carried interest taxation allows private equity and hedge fund managers to treat performance fees (typically 20% of fund returns) as capital gains instead of ordinary income, although recent reform proposals suggest this tax advantage elimination. Investors pay ordinary income rates when selling shares following IPOs or acquisitions.

Cryptocurrency Tax Rules

While evolving quickly across global tax jurisdictions as adoption increases, cryptocurrency tax guidance generally treats digital currencies as property instead of cash, with rules dependent on factors like short or long-term holding periods. Proper documentation around cost basis and profit/losses proves essential for accurate tax reporting.

Real Estate and Energy Investments

Tax-advantaged structures in real estate investments include Delaware Statutory Trusts (DST) and Opportunity Zone investments allowing tax deferrals on capital gains to incentivize development projects in certain geographic areas. Master Limited Partnerships (MLPs) frequently contain oil and gas assets that offer tax efficiencies.

Collectible Investments

Fine art and other tangible collectibles meeting specific criteria can qualify for favorable capital gains rates instead of higher ordinary income rates when sold at a profit. Certified appraisal documentation serves a key role in substantiating basis and deductions.

Key Characteristics of Alternative Investments

While varied in focus and structure, alternatives as an asset class carry unifying traits around fees, transparency, liquidity, regulation, and barriers to entry.

Here is the continuation from High Investment Minimums:

High Investment Minimums

Lofty capital requirements create restrictions for average investors. Private equity funds and venture capital vehicles commonly mandate $250,000, $500,000 or more to participate. Even accessible options like managed futures can require $25,000 or higher initial investments.

Lower Transparency and Verification

Compared to public stocks filing quarterly and annual financial reports, alternatives have minimal reporting requirements and disclose little regarding holdings, valuations, or position details. Assurances around integrity and security fall heavily on fund governance and internal controls.

Less Liquidity

Lock-up periods preventing any withdrawals for 1-5 years enable managers to invest in illiquid assets without dealing with redemption requests. Trying to exit early frequently triggers substantial early withdrawal penalties. Even mature funds limit withdrawal capacity. This illiquidity contrasts sharply with listed stocks tradable daily.

Limited Investor Pool

Most individual investors lack sufficient assets or income levels to qualify for certain alternatives like hedge funds, managed futures funds, and private equity offerings with high net worth or accredited investor standards. Availability focuses on institutions like pensions, endowments, family offices plus wealthy individuals.

Restricted Regulatory Oversight

Through nuanced legal structures or registration exemptions, alternative asset managers secure designation outside typical definitions of retail securities. This leads to relaxed reporting rules and disclosure compared to registered stock offerings. Managers enjoy greater flexibility but with less formal external governance.

Why Institutions Value Alternatives

Pension funds, university endowments, and sizable family offices dedicating large portfolio percentages to alternatives shed light on the merits institutions see.

Low Correlation to Traditional Assets

Institutions emphasize alternatives for diversification benefits relative to conventional securities like publicly traded stocks and bonds. Allocations between 20-40% across alternatives help manage overall portfolio risk.

Inflation Hedging Properties

During periods of escalating inflation, real asset exposure offers inherent protection while bonds lose value. Timberland, farmland, real estate, oil, and gas provide hard assets maintaining intrinsic value as paper currency gets devalued by rising prices.

Asymmetric Returns

While more volatile, alternatives like venture capital, leveraged buyouts, distressed investing, and structured credit allow skilled managers to generate outsized returns – 30%+ in some instances – unachievable in plain vanilla stock and bond investing. Capturing full upside favors simple fee structures vs. typical 2/20 arrangements.

Standards Around Alternatives

Regulators delineate alternatives from traditional retail investment securities, leading to bespoke requirements around disclosures, reporting, and participation.

SEC Registration Exemptions

Private equity funds, venture capital vehicles, hedge funds, and other alternatives utilize legal structures and accredited investor exemptions to avoid registering as public investment companies under the Investment Company Act of 1940, which necessitates extensive disclosures.

Availability Restriction

By limiting participation to institutions and wealthy investors meeting accredited standards, alternatives bypass regulations protecting mainstream retail investors, under the premise of elevated risk. Most countries delineate greater protection standards for unsophisticated investors up to certain income and asset minimums.

Opaque Practices

Alternative managers reveal minimal information on positions, valuations, mark-to-market accounting, fee structures, and key person risk. Even mandatory SEC filings for private equity groups and hedge fund managers avoid position specifics. This lack of transparency relies heavily on the ethics and governance of fund management.

Frequently Asked Questions

 

How Liquid Are These Investments?

Liquidity varies widely across alternatives. Cryptocurrencies offer immediate tradability while private equity and venture capital lock up capital for years. Trying to exit hedge funds early often limits withdrawal amounts and triggers fees. Investors must accept illiquidity with alternatives more so than traditional securities.

What Are the Tax Implications?

Tax treatment shifts extensively based on the type of alternative investment. Private fund-carried interest enables managers to use preferential capital gains rates. Cryptocurrencies get categorized as property instead of currency or securities. Many real estate platforms provide tax-deferred or tax-exempt options. Professional advice assists navigation.

What Are the Fees and Costs?

Alternatives levy extensive layers of fees including management fees, performance fees, early withdrawal penalties, sales loads, administration costs, and more. Modeling projected returns should assume 2-3% in base fees plus 20% of profits. High costs necessitate high gross returns.

What Is the Historical Performance?

Assessing the performance of alternatives as an asset class proves difficult given the extreme variance across strategies. Average private equity returns may land 10-15% above public markets over decades but subsets like venture capital vary wildly based on stage, sector, and vintage. Commodity futures oscillate with economic cycles. Fraught comparisons argue for assessing each investment’s merits independently.

Conclusion

The growing appetite for alternative investments speaks to their portfolio enhancement potential when thoughtfully integrated. However prudent investors must weigh illiquidity, risk factors, and regulatory considerations against expected diversification and return premiums compared to traditional securities.

As alternatives mature and reach broader adoption, policymakers continue addressing systemic risks, investor protections, and taxation nuances. This evolution will likely persist over years to come. In the meantime, extensive due diligence, measured expectations, and gradual exposure aid responsible allocation for suitable investors.