Navigating Between Traditional and Alternative Investments
Alternative Investments vs Traditional Investments: Making sound investment decisions is critical for building long-term wealth. When constructing a sustainable investment portfolio, investors have two major categories to choose from: traditional investments and alternative investments.
This guide provides an in-depth look at both types, their key differences, pros and cons, and factors to consider when deciding between the two approaches.
Key Takeaways
- Traditional investments include stocks, bonds, cash, and mutual funds
- Alternative investments include private equity, venture capital, hedge funds, real estate, infrastructure, commodities, etc.
- The main differences relate to liquidity, risk, regulation, fees, and barriers to entry
- Both approaches have unique advantages and disadvantages to weigh
- Ideal portfolio allocation depends on individual goals, time horizon, risk tolerance
Take A Look At: Maximizing Returns with Alternative Investments: A Comprehensive Guide
Alternative Investments vs Traditional Investments
Alternative Investments
Alternative investments refer to assets that fall outside the conventional categories of stocks, bonds, and cash. They encompass a wide variety of strategies with the common theme of offering diversification beyond traditional market dynamics.
Common alternative investment examples include:
- Private equity and venture capital
- Hedge funds
- Managed futures
- Real estate and REITs
- Infrastructure
- Precious metals
- Art and collectibles
Alternative investments have seen rising interest in recent years among institutional investors like pensions, endowments, family offices seeking higher returns, and portfolio diversification.
Traditional Investments
Traditional investments consist of the basic building blocks many investors opt for when first constructing a portfolio:
The main traditional asset classes are:
- Stocks – represent ownership in publicly traded companies
- Bonds – essentially loans issued by corporations or governments
- Cash equivalents like money market funds
- Mutual funds or ETFs – bundle various stocks and bonds
These tend to be more familiar, regulated, and accessible options for the average individual investor. Portfolios based solely on stocks and bonds have delivered solid long-run historical returns.
Key Differences Between Alternative and Traditional Investments
While both alternative and traditional investments aim to generate returns and manage risk, they differ significantly across several dimensions:
Liquidity Differences
Traditional investments, especially stocks and bonds, trade daily on exchanges allowing investors to buy and sell easily. There is high liquidity.
Alternative investments like private equity involve committing capital for multi-year periods with restricted liquidity upfront.
Risk and Return Profiles
Equities and fixed-income returns tend to be lower, steadier, and more dependent on markets. Alternative returns can be higher but with larger dispersion and lower correlation to markets.
Correlation to Markets
Traditional assets tend to rise and fall together tied to economic cycles. Alternatives behave differently providing portfolio diversification benefits.
Investment Time Horizons
Traditional investments focus more on short to medium-term periods. Alternatives often require long-term 5-10+ year lockups to achieve target returns.
Regulation Differences
Traditional market Exposure comes through highly regulated venues like stock exchanges. Much of alt investing occurs in complex less regulated private markets.
Also See: Understanding The Risks of Alternative Investments
Minimum Investments
While traditional assets have low minimums, alternatives often require high accredited investor minimums given their complexity.
Fees and Expenses
Traditional index fund fees are extremely low, while alternatives charge higher fees due to active management and less efficiency.
| Alternative Investments | Traditional Investments | |
|---|---|---|
| Example Asset Classes | Private equity, hedge funds, venture capital, real estate, commodities | Stocks, bonds, cash, mutual funds |
| Liquidity | Lower/illiquid | Higher/liquid |
| Risk Profile | Higher with more variability | Lower with more consistency |
| Return Potential | Higher over long-term | Lower over long-term |
| Investment Horizon | Long-term / 5-10+ years | Short to medium-term |
| Regulation | Less regulated | Heavily regulated |
| Barriers to Entry | Higher minimums, accredited status | Lower minimums are more accessible |
| Fees | Higher 2 and 20 fee structures | Lower expense ratios |
Pros and Cons of Alternative Investments
Pros
Alternative investments can enhance portfolio diversification, reduce volatility, and boost returns:
- Diversification – Alternatives have low correlation providing diversification benefits that smooth out portfolio volatility over market cycles.
- Lower market correlation – Private equity, venture capital, real assets, and absolute return strategies behave differently than public stocks and bonds, preserving capital better in market downturns.
- Higher return potential – Illiquidity and complexity risk premia mean certain alternative vehicles can offer excess returns over extended periods.
Cons
Despite their advantages, alt investments have limitations to consider:
- Higher fees – Complex due diligence, customized reporting, specialized expertise, and smaller asset pools make alternatives more expensive.
- Lower liquidity – Unlike daily trading of stocks, it can be years before private capital is returned during a specified period.
- Higher minimums – Due to more complexity and smaller size, alternative funds set higher minimum investments, often 7 figures.
- Complex diligence – Opaque strategies and less reporting require deeper analysis of track record, operations, and manager integrity.
In short, increased complexity brings diversification benefits but requires paying liquidity, knowledge, expertise, and access premiums.
Consider: Types of Alternative Investments: An In-Depth Guide
Pros and Cons of Traditional Investments
Pros
Traditional stocks, bonds, and mutual funds have key advantages:
- High liquidity – As publicly traded securities, investors enjoy daily liquidity to enter and exit positions.
- Lower investment minimums – Investors can purchase traditional assets commission-free these days in small increments.
- More transparency – As SEC-registered securities with high regulation, traditional investments involve transparent reporting.
- Simpler investments – Basic securities like stocks and bonds are easier to analyze compared to complex alt strategies.
Cons
However, traditional investments have limitations like:
- Higher volatility – A close correlation to economic cycles means traditional portfolios face larger drawdowns during broader market declines.
- Lower return potential – Greater regulation and restrictions capped the upside over long horizons for public stocks and bonds.
While traditional investments offer simplicity, liquidity, and low costs, they sacrifice some diversification benefits and absolute return potential.
Who Alternative Investments Are Best Suited For
Given higher complexity and entry barriers, alternative investments tend to appeal to a narrower subset of investor types:
- Accredited investors – Those meeting high net worth or income thresholds for the sake of investor protection.
- Institutional investors – Pensions, endowments, foundations with long time horizons, and large staffs to conduct manager diligence.
- Those with longer timelines – Illiquidity premiums mean harvesting alternative risk premia requires 5-10+ year outlooks.
- Investors wanting diversification – Allocating 20-40% to alternatives helps smooth volatility and boost portfolio efficiency.
While alternatives have historically been confined to elite institutional investors, new legislation and fintech innovation are improving access for qualifying retail investors.
Examples of the Most Common Alternative Investment Types
There exists a wide universe of alternative investment strategies and structures. Some of the most common include:
- Private equity – Private investing in mature companies not traded on public markets
- Venture capital – Investing in early-stage startups before they IPO
- Hedge funds – Employ sophisticated techniques to generate absolute returns
- Managed futures – Trading liquid futures contracts across asset classes
- Real estate – Investing in physical property or real estate securities
- Infrastructure – Investing in critical backbone assets like roads, cell towers
- Precious metals – Owning physical gold, silver, platinum for inflation hedging
- Art and collectibles – Wine, watches, classic cars, sports memorabilia
Each alternative category serves a specific portfolio purpose based on risk budgets and return objectives.
| Asset Class | Target Net Return Range |
|---|---|
| Money Market Funds | 1-3% |
| Fixed Income | 3-6% |
| Public Equities | 8-11% |
| Private Equity | 12-20% |
| Venture Capital | 15-25%+ |
| Hedge Funds | 10-15% (depending on strategy) |
Ways Individuals Can Gain Alternative Investment Exposure
While alternatives have traditionally been restricted to qualified purchasers, new legislation and financial innovation now facilitate wider access:
- Interval funds – Provide periodic liquidity windows to investors
- Some ETFs – Publicly traded funds providing alternative strategy exposure
- Equity crowdfunding – Enables backing startups online with relaxed requirements
- Fund of funds – Bundle various alt funds for simplified access
- Offshore funds – Non-US investors can access certain funds abroad
- Secondary marketplaces – Allow trading of alternative asset interests
Platform improvements now enable smaller retail investors to access the return potential and diversification of alternatives to sensibly allocate beyond traditional stocks and bonds.
Factors to Consider Before Investing in Alternatives
While alternatives offer unique advantages, they require extra careful evaluation:
- Ensure proper diversification – Alternatives behave differently so evaluate the impact on overall portfolio volatility.
- Conduct thorough due diligence – Validate manager track record and strategy integrity to justify higher costs.
- Understand risks and fees – Model various scenarios with assumptions around liquidity constraints, loss potential, and all expenses.
- Consider investment timelines – Factor in required holding periods and manage liquidity needs.
Investing outside traditional assets brings bigger learning curves. Taking a systematic approach is key.
Tips for Getting Started With Alternative Investments
For suitable investors new to alternatives, adopt a gradual approach:
- Consider starting small – Allocate 5-10% of your portfolio to alternatives to test strategies and better understand unique dynamics.
- Enlist the help of a financial advisor – An SEC-registered investment advisor experienced with alternatives can provide guidance around portfolio fit, manager selection, due diligence, and risk management.
- Leverage online alternative investment platforms – New fintech platforms allow investors to browse investment offerings, access educational resources, and invest in alt vehicles online. This can simplify the learning curve through better discovery and user experience.
Take time to learn the pros, cons, and risks associated with this asset class. Evaluate if certain strategies align with your requirements and risk tolerances.
| Platform | Details |
|---|---|
| EquityZen | Secondary marketplace providing access to pre-IPO companies |
| AngelList | A platform for investing in startups and private equity |
| Yieldstreet | Access to alternative income-generating asset classes |
| Masterworks | Art & collectibles investment platform |
Frequently Asked Questions
Below are some common questions about integrating alternatives:
What is the ideal allocation percentage for alternative investments in my portfolio?
There is no universally ideal ratio, as each investor has unique goals and risk constraints. However, many experts suggest allocating between 10-40% of a portfolio into well-diversified alternative assets. Yale and Harvard’s endowments allocate over 50% to alternatives given their long time horizon and return objectives. The ideal amount depends on your liquidity needs, risk appetite, age, wealth level, and other personal finance priorities.
What are the typical investment minimums required for alternatives?
Given the complex and private nature of many alternatives like hedge funds and private equity, minimum investment amounts tend to be much higher than traditional options. While stocks may only require $100 minimum, many alternative vehicles start at $50,000 and can reach well into the millions. However, newer fintech platforms and more accessible fund structures like interval funds are lowering minimums for some strategies.
Can I expect higher returns from alternative investments?
On a risk-adjusted basis, most alternatives have delivered returns in the 6-15% net IRR target range over longer 5 to 10-year holding periods. Strategies like private equity, venture capital and certain hedge fund styles have outperformed public equity and bond benchmarks historically, especially during crisis periods. However, past performance never guarantees future returns. Each strategy has unique risk factors to model out.
Is it advisable to include alternatives in my retirement accounts?
While 401ks and IRAs have regulatory restrictions on what can be included, the landscape is improving for select alternatives. Certain registered liquid alternative mutual funds and ETFs meeting DOL standards can now be held in retirement accounts. Additionally, some self-directed IRA providers give more flexibility. Given limitations, however, it is best to first seek guidance from an experienced Registered Investment Advisor on integration.
Please let me know if you would like me to expand on any area of the frequently asked questions section further with additional details. I aimed to provide more comprehensive responses for each question here.
Conclusion
Alternative investments have unique risk-return profiles versus traditional assets. When aligned with an investor’s timeframe, knowledge, risk appetite, and portfolio construction needs, integrating alternatives can provide diversification, inflation hedging, and enhanced absolute returns over market cycles – a value proposition with increasing appeal.
As with any investment, assessing suitability across all aspects of personal finance is crucial before allocating to alternatives. Adopting a long-term outlook and systematic learning approach allows suitable investors to tap into return drivers beyond just stocks and bonds to better achieve their investment objectives.
