Types of Alternative Investments: An In-Depth Guide

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Alternative investments refer to assets that fall outside the traditional categories of stocks, bonds, and cash. As investors seek to diversify beyond just stocks and bonds, alternatives have grown increasingly popular for their return potential, diversification benefits, and inflation-hedging abilities. This guide provides an in-depth overview of major alternative investment types that investors should consider.

Table of Contents

Key Takeaways: Alternative Investment Options

Investment Type	Return Potential	Risk Level	Liquidity	Minimum Investment
Private Equity	High	High	Low	$100K+
Hedge Funds	Varies	Moderate-High	Quarterly-Annual	$100K
Real Estate	Mid-High	Mid-Low	Low-Moderate	$1K+
Infrastructure	Mid-High	Low-Moderate	Low	$5K+
Farmland	Mid	Low	Low	$25K+
Natural Resources	Highly Variable	High	Low	$10K+

Types of Alternative Investments

Private Equity

Private equity broadly refers to investments in private, non-publicly traded companies. It encompasses various categories:

Venture Capital: Funding startup and early-stage businesses with high growth potential
Leveraged Buyouts: Using debt to acquire mature companies, increase value, and resell at a profit
Growth Capital: Investing in established mid-sized companies to expand operations

Overview of Private Equity

Illiquidity tradeoff for potentially higher returns
Long investment timelines from 5-10+ years
Invest alongside firms like KKR, Blackstone, Carlyle Group
High risk – have tolerance for potential complete losses
Requires accredited investor status

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Minimum investments range from $100K to $5M+. Returns historically average 20%+ annually when successful. However, the failure rate of VC investments is almost 75%, underscoring the risky nature.

Private Equity Type	10 Year Returns	20 Year Returns
Venture Capital	25%	35%
Leveraged Buyouts	15%	18%
Growth Equity	21%	23%

Tax Considerations

Private equity investments generate primarily capital gains tax when profitably exited. Investors avoid dividend taxes which boosts overall gains. Foreign investors may also enjoy tax exemptions on foreign-sourced capital gains. Management fees and other expenses can be used to offset some tax liability.

Hedge Funds

Hedge funds actively invest pooled capital across a range of assets and strategies while aiming to generate steady, positive returns regardless of overall market conditions.

Some major hedge fund strategies include:

Long/short equity
Event-driven (merger arbitrage)
Distressed/high-yield investing
Global macro

Compared to mutual funds, hedge funds tend to have:

Higher minimum investments ($100K+)
Higher fees (typical “2 & 20” model)
Less diversification & liquidity
Less regulatory oversight and reporting

However, they offer enhanced diversification from traditional stocks/bond investments into strategies normally available only to institutions.

Strategy	1 Year Return	3 Year Annualized Return	Max Drawdown
Equity Long/Short	7%	5%	-8%
Event-Driven	4%	6%	-5%
Global Macro	3%	4%	-11%

Performance & Evaluation

Historical annual returns for hedge funds from 1996-2019 average around 8.6%. However, a properly structured hedge fund portfolio mix delivered closer to a 10-11% historical return profile. Evaluating individual hedge funds requires assessing:

Long-term returns/volatility measures (5yr+, max drawdowns)
Returns in different market environments (up, down, flat markets)
Risk-adjusted return metrics (Sharpe, alpha, beta)

This quantifiable performance analysis determines if higher fees paid to hedge fund managers is truly merited by risk-adjusted results.

Real Estate Investment Options

Investors enjoy multiple options to gain exposure to real estate – from liquid securities to direct ownership:

sset Class	20 Year Annualized Returns
REITs	10.3%
S&P 500	6.1%
US Bonds	5.9%
US Stocks	7.8%

Public Investment Vehicles

REITs – Generate returns from income-producing commercial properties
Public real estate companies (REOCs)
Real estate index funds/ETFs

Private Real Estate Investing

Direct physical property purchases – residential/commercial rentals, raw land, etc.
Hard money lending – High-interest rate lending for real estate investors/developers
Real estate syndications/crowdfunding – Pool money to assemble property assets

Each option carries different risk, liquidity, and return profiles from land entitlement plays to buy-and-hold rentals. Geographic location also introduces hugely variable factors regarding market demand drivers, property taxes, and more.

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Investor Considerations

Those investing in real estate should consider factors like:

Passive or active involvement preferences
Hands-on management capabilities
Loan management familiarity
Timeline of funds needed (lockup considerations)
Tax implications – understanding 1031 exchanges, depreciation schedules, carried interest, etc.

Real estate serves as an inflation hedge and the deeply cyclical nature allows buying low at the right times. Value plays on distressed properties often provide opportunistic returns for enterprising investors.

Investing in Global Infrastructure

Its essential role offers a stable cash flow profile throughout market cycles. With global population growth and urbanization accelerating, massive capital expenditure continues, underpinning infrastructure asset investing.

Governments increasingly privatize infrastructure assets to raise funding. These global investments into roads, airports, utilities, and pipelines produce returns largely uncorrelated to traditional asset classes. Significant barriers to entry characterize the sector with high costs, strict regulations, and limited competition.

Midstream oil/gas pipelines and contracted renewable power assets provide yields topping 6-10% [2]. Infrastructure’s monopolistic traits enhance its inflation-hedging abilities relative to stocks/bonds during rising price environments. Investors get exposure through:

Diversified funds
Direct project bonds
Public securities
Private Equity

Agriculture: Investing in Farmland

Farmland exhibits reliable appreciation exceeding inflation over decades. The rising global population lifts long-term arable land values. Institutional investors like pension funds continue acquiring farmland assets.

Period	Average Annual Increase
1950-2019	5.9%
2000-2020	8.3%
2010-2020	4.6%

Structuring Ownership

Investors buy physical land for cash leasing to farmers or participate via:

REITs specializing in farmland
Private equity companies assembling portfolios
Crowdfunding enables investors to buy shares of farms

Stanford University’s Endowment has generated excellent risk-adjusted returns, averaging 11% annually from its $3 billion+ agriculture portfolio.

However, farmland carries risks regarding weather patterns, commodity cycles, and regional economic health. Thorough vetting of operators and geographic factors provides the basis for prudent investing.

Investing in Natural Resources

Natural resources investments include categories like metals, mining, oil and gas exploration firms, timber REITs, and commodities themselves. Companies involved in extracting or producing resources can generate extremely high returns. However, they exhibit much higher volatility compared to bonds/S&P 500 [4].

Direct ownership of producing land or royalty rights delivers attractive cash flow. Investors also participate in commodity futures to speculate on supply/demand dynamics driving prices. Precious metals like gold/silver serve as popular portfolio diversifiers and inflation hedges due to limited supply.

Overall, research confirms that adding 6-15% allocation to commodities enhances portfolio efficiency and risk-adjusted returns [5]. However, investors must conduct extensive due diligence given capital expenditure is vital for maintaining production volumes. Threats like shifting clean energy policies present additional risks to evaluate.

Comparing Investment Characteristics – Types of Alternative Investments

Choosing among alternatives depends greatly on personal factors driving investing decisions in the first place:

Comparing Liquidity Timelines

Liquidity refers to how fast an investment can convert into cash. This becomes important when investors require funds for near-term needs.

Most Liquid

Public stocks/bonds – Can liquidate within 1-3 days
Commodity futures – Settle daily or monthly
REITs – Priced and traded intraday like stocks

Semi-Liquid

Hedge funds – Monthly-Quarterly redemption rights
Equipment leases – Periodic rental payments over years

Illiquid

Direct real estate/farmland – Months to sell physical property
Private equity – 5-10+ year lockup periods common

With illiquid alternatives, investors commit capital for a defined holding period. Attempts to exit early often incur substantial penalties. This favors investors with longer time horizons.

Due Diligence Timelines

Proper due diligence directly impacts realized returns and prevents capital losses from fraud or mismanagement. Complexity and deal structures vary drastically.

Evaluating traditional public stocks or index funds requires fairly minimal vetting of financials. In contrast, evaluating alternatives like private credit funds or agriculture land deals could take months to complete a detailed analysis of:

Operational and financial metrics
Management track records
Growth drivers and macro environment
Legality and compliance

Having proper advisor relationships facilitates efficient due diligence. This helps set realistic expectations on timelines to fully understand the specifics of a given investment opportunity before finalizing capital commitments.

Tax Considerations

Tax treatment differs substantially among alternative investments, from PTP pass-through structures to C-corp dividends. Several allow tax-advantaged treatment. Understanding terms upfront enables better projection of net, after-tax returns.

Some tax efficiencies gained:

Accelerated depreciation lowers current tax liability in real estate
Deferred taxation on gains re-invested through opportunity funds
Carried interest enabling private equity/VC managers to receive a share of profits taxed as capital gains vs income

Evaluating Risk-Adjusted Returns

Ultimately investors decide if pursuing alternatives warrants the higher fees, lower liquidity, and more intense due diligence requirements. The rewards target enhanced portfolio efficiency.

Customized benchmarking better determines if alternatives provide their intended diversification and return enhancement. Metrics like Sharpe ratios or alpha for sophisticated investors illustrate if alternatives truly reduce overall portfolio volatility on a risk-adjusted basis.

Both quantitative and qualitative factors ensure alternatives merit inclusion. Patient investors reap outsized rewards but must gauge if anticipated returns justify the patience and extra risk compartments required.

Is It Worth Investing in Alternative Assets?

Well-constructed alternative investment portfolios enhance returns for those investors disciplined enough to accept certain tradeoffs accompanying the private capital markets. As with any investments, individuals must weigh personal factors, remain educated on changing regulations, and work with qualified advisors.

Choosing the Right Investments

Conduct Extensive Due Diligence

Especially for private deals, extensively vet the sponsors, deal history, financials, and strategy to gauge alignment with your goals.

Diversify Across Strategies

Mixing alternatives low on correlation regulates volatility. Blend private equity, real asset income streams, commodities, and hedge fund techniques

Work with Specialized Alternative Advisors

Let experienced advisors source thoroughly researched deals, conduct due diligence, handle legalities, and manage ongoing compliance

Invest Incrementally

Wade into alternatives leveraging portfolio size increases. Build sufficient experience before major allocation expansion.

Focus on Tailored Portfolio Goals

Keep central portfolio objectives for return targets, liquidity needs, and risk tolerance front and center when adjusting the alternatives mix.

Conclusion

From real estate to farmland, well-selected alternative investments diversify portfolios into assets delivering returns less tied to traditional stock and bond performance. Their portfolio mix merits consideration to regulate volatility and hedge inflation.

Investors willing to accept tradeoffs accompanying lower liquidity and higher due diligence hurdles gain access to return-enhancing opportunities normally reserved only for institutional investors. Of course, countless risks span geopolitical, environmental, financial, and operational factors. Maintaining diligent monitoring and risk management frameworks, alongside manager accountability,

keeps probability favoring positive outcomes. Qualified investors who approach alternatives with eyes wide open stand to reap their performance enhancement rewards for years to come.