Pros and Cons of Alternative Investments
According to a new Preqin report, alternative assets have surged in popularity recently. In 2021, transactions were around $13 trillion, and that number is expected to grow to $23 trillion by 2026. There also are more readily available funds now with lower minimums. No longer is it only large institutions, endowments, and family offices who can buy these funds. There are also new fin-tech companies which can facilitate direct investment or have multi managers with as little as $100,000.
What exactly is an alternative investment?
Alternate investments are strategies that differentiate from traditional stocks and bonds. They can include real estate, hedge funds, private equity or venture capital, long-short trading, commodities and managed futures, art and collectables. They are, however, not readily available for most investors. The average investor cannot easily go and purchase some for small investment. They usually require much higher minimums, as well as other qualifications such as the purchaser being an accredited investor.
Reg D of the Securities Act 1933 sets the terms for what it means to be an accredited investor. According to the SEC, someone can be an accredited investor in one of two ways. First, he or she must be someone with an income exceeding $200,000 for each of the last two years or a joint income exceeding $300,000 for those years. Alternatively, he or she must be an individual whose net worth, excluding the value of a primary residence, of more than $1,000,000. As of the summer of 2020, individuals holding certain licenses like the Series 7, Series 65, and Series 82 are now included in this definition. Also, those with in-depth industry knowledge and other relevant certifications or designations can now be considered an accredited investor.
Why would an accredited investor invest in alternatives?
Let’s look first and foremost at behavioral motivation. From this standpoint, it seems like people invest in these alternatives because they are seen as special based on the fact that they are selective and exclusive. It has its own niche market and people love being part of a niche market. Even with these attractions, though, the industry standards suggest that those who can should usually invest no more than 20% of their portfolio into alternatives. This advice follows the same principle as the single stock exposure of not investing more than 10% in any one fund.
A second reason investors invest in alternatives is because they have low correlations to standard stocks and bonds, so they provide some diversification while also providing the opportunity for higher returns. However, if their potential rewards increase, then so do their risks. These funds can be less transparent about what they purchase, and they usually have fewer regulations from U.S. Securities and Exchange Commission (SEC). They are also more illiquid and can be tied up for longer periods of time. Therefore, it would be important to really understand what you are investing in or the track record of the investment management company if you chose to pursue alternative investments.
Do you have a financial plan in place?
If you are considering alternative investments, it is important to do so with a financial plan in place. Most investors need to focus first on getting rid of debt, having emergency savings, and maxing out retirement accounts before looking to alternative investments. This traditional track is still the best way to reach your financial goals. Any additional gains from alternatives should be viewed only as a way to create surplus or additional gains. Also, we still believe one of the best places to invest for the future is the stock and bond market through broad based diversification of ETFs of various asset classes. However, if you are in a financial position where you can comfortably look at diversifying with some riskier, less liquid investments, alternatives can provide some options. Just be careful to do your due diligence first.
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Matthews Barnett, CFP®, ChFC®, CLU®