Alternative Investments: What They Are, Types, Benefits & Key Risks

Alternative investments offer access to asset classes beyond stocks and bonds—often with higher return potential and unique risk profiles. From private equity and hedge funds to real estate, commodities, and collectibles, these non-traditional investments can enhance diversification and hedge against market volatility. In this guide, we’ll explain what alternative investments are, explore their pros and cons, and help you determine where they might fit in your portfolio.

KEY TAKEAWAYS

• Alternative investments include assets beyond traditional stocks, bonds, and cash, such as private equity, hedge funds, real estate, commodities, and collectibles
• These investments typically offer portfolio diversification and potential for higher returns but come with increased risk and lower liquidity
• Most alternative investments require higher minimum investments and are often limited to accredited investors
• Alternative assets generally have low correlation with traditional markets, providing a hedge against market volatility
• Due diligence is crucial as these investments often lack transparency and have complex fee structures

What Are Alternative Investments?

Alternative investments represent a broad category of assets that fall outside the traditional investment triad of stocks, bonds, and cash. These non-traditional investments encompass everything from private equity and hedge funds to real estate, commodities, and even fine art or wine. As institutional investors have long recognized their value, alternative investments are increasingly becoming accessible to individual investors seeking to diversify their portfolios beyond conventional markets.

The fundamental distinction of alternative investments lies in their unique characteristics: they typically demonstrate low correlation with traditional markets, employ different investment strategies, and often require specialized knowledge to evaluate properly. While traditional investments trade on public exchanges with transparent pricing, alternative investments frequently operate in private markets with limited liquidity and less regulatory oversight.

Types of Alternative Investments

Private Equity

Private equity involves investing directly in private companies or buying out public companies to delist them from stock exchanges. These investments typically focus on companies with high growth potential or those requiring operational improvements. Private equity firms pool capital from investors to acquire stakes in businesses, implement strategic changes, and eventually exit through sales or public offerings.

The private equity landscape includes:

• Venture capital (early-stage companies)
• Growth equity (established companies seeking expansion capital)
• Buyout funds (acquiring controlling stakes in mature companies)
• Distressed debt (investing in troubled companies)

Hedge Funds

Hedge funds employ sophisticated investment strategies to generate returns regardless of market conditions. Unlike mutual funds, hedge funds can use leverage, short selling, derivatives, and other complex techniques to achieve their investment objectives. They operate with fewer regulatory constraints but typically require substantial minimum investments.

Common hedge fund strategies include:

• Long/short equity (buying undervalued stocks while shorting overvalued ones)
• Market neutral (minimizing market risk through balanced long and short positions)
• Global macro (betting on economic trends across countries and asset classes)
• Event-driven (capitalizing on corporate events like mergers or bankruptcies)

Real Estate

Real estate investments extend beyond direct property ownership to include various vehicles that provide exposure to the property market. These investments can generate income through rent and appreciation through property value increases.

Real estate investment options include:

• Direct property ownership (residential, commercial, industrial)
• Real Estate Investment Trusts (REITs)
• Real estate crowdfunding platforms
• Real estate limited partnerships
• Property development projects

Commodities

Commodities represent physical goods such as agricultural products, metals, and energy resources. Investors can gain exposure to commodities through various methods, each offering different levels of complexity and risk.

Commodity investment approaches:

• Physical ownership (gold bars, silver coins)
• Futures contracts
• Commodity ETFs and mutual funds
• Commodity-focused stocks (mining companies, agricultural businesses)

Collectibles and Art

Tangible assets like art, wine, classic cars, and rare coins constitute another category of alternative investments. These passion investments combine personal enjoyment with potential financial returns, though they require specialized knowledge and careful authentication.

Popular collectible investments:

• Fine art and sculptures
• Rare wines and spirits
• Classic and vintage automobiles
• Rare stamps and coins
• Sports memorabilia

Cryptocurrency and Digital Assets

The emergence of blockchain technology has created a new class of alternative investments. Cryptocurrencies and digital assets offer unique characteristics, including decentralization, transparency, and potential for significant returns, albeit with considerable volatility.

Digital asset categories:

• Cryptocurrencies (Bitcoin, Ethereum)
• Non-fungible tokens (NFTs)
• Decentralized finance (DeFi) protocols
• Security tokens

Benefits of Alternative Investments

Portfolio Diversification

Alternative investments provide crucial diversification benefits by exhibiting low correlation with traditional asset classes. When stock markets decline, certain alternatives like gold or managed futures may maintain or increase in value, helping to cushion portfolio losses. This non-correlated behavior stems from different underlying value drivers—while stocks respond to corporate earnings and economic growth, commodities might react to supply-demand dynamics or weather patterns.

Potential for Higher Returns

Many alternative investments offer the possibility of returns that exceed traditional market benchmarks. Private equity firms, for instance, can create value through operational improvements and strategic repositioning that public market investors cannot achieve. Hedge funds may exploit market inefficiencies or employ leverage to amplify returns. However, these higher return potentials come with commensurate risks.

Inflation Protection

Certain alternative investments serve as effective hedges against inflation. Real estate and commodities, in particular, tend to maintain their value during inflationary periods as their prices often rise with general price levels. This characteristic makes them valuable portfolio components during times of currency devaluation or rising prices.

Access to Unique Opportunities

Alternative investments open doors to opportunities unavailable in public markets. Venture capital allows participation in innovative startups before they go public. Art investments enable ownership of culturally significant works while potentially benefiting from appreciation. These unique opportunities can provide both financial and non-financial rewards.

Risks and Challenges

Liquidity Constraints

Most alternative investments suffer from limited liquidity compared to publicly traded securities. Private equity investments often have lock-up periods of several years. Real estate transactions can take months to complete. Art and collectibles may have thin markets with few buyers. This illiquidity means investors cannot easily convert their holdings to cash when needed.

High Fees and Expenses

Alternative investments typically carry higher fee structures than traditional investments. Hedge funds commonly charge "2 and 20"—a 2% management fee plus 20% of profits. Private equity funds have similar arrangements, plus additional expenses for due diligence and transactions. These fees can significantly impact net returns, especially during periods of modest performance.

Limited Transparency

Many alternative investments operate with less transparency than public securities. Private companies don't file regular financial statements. Hedge funds may not fully disclose their strategies or positions. This opacity makes it difficult for investors to properly evaluate risks or monitor performance.

Regulatory Limitations

Alternative investments often face regulatory restrictions that limit access to accredited investors—those meeting specific income or net worth thresholds. These regulations aim to protect less sophisticated investors but also restrict opportunities for portfolio diversification among retail investors.

Complexity and Due Diligence Requirements

Understanding alternative investments requires specialized knowledge. Evaluating a private equity opportunity demands different skills than analyzing public stocks. Assessing art authenticity and value requires expertise in art history and market dynamics. This complexity necessitates extensive due diligence and often professional advice.

How to Invest in Alternatives

Direct Investment

Wealthy individuals can invest directly in alternative assets by purchasing real estate, buying physical commodities, or acquiring collectibles. Direct investment provides maximum control but requires substantial capital, expertise, and ongoing management.

Fund Structures

Most investors access alternatives through fund structures:

• Limited partnerships (common for private equity and hedge funds)
• Mutual funds focused on alternatives
• Exchange-traded funds (ETFs) tracking alternative strategies
• Interval funds offering periodic liquidity
• Registered investment companies providing retail access

Platform Solutions

Technology has democratized access to alternatives through various platforms:

• Real estate crowdfunding sites
• Art investment platforms
• Peer-to-peer lending networks
• Cryptocurrency exchanges
• Robo-advisors offering alternative allocations

Alternative Investment Trusts

Publicly traded vehicles provide liquid exposure to alternative strategies:

• Real Estate Investment Trusts (REITs)
• Business Development Companies (BDCs)
• Master Limited Partnerships (MLPs)
• Closed-end funds focusing on alternatives

Due Diligence Considerations

Manager Evaluation

When investing through funds, thoroughly evaluate the management team:

• Track record and experience
• Investment philosophy and process
• Risk management procedures
• Organizational stability
• Alignment of interests

Fee Analysis

Carefully analyze all fees and expenses:

• Management fees
• Performance fees
• Administrative costs
• Transaction expenses
• Early redemption penalties

Risk Assessment

Understand specific risks associated with each alternative:

• Market risks
• Operational risks
• Counterparty risks
• Regulatory risks
• Liquidity risks

Legal and Tax Implications

Alternative investments often have complex legal and tax structures:

• Partnership agreements
• Tax reporting requirements
• Estate planning considerations
• International tax implications
• Regulatory compliance

Who Should Consider Alternative Investments?

Accredited Investors

Many alternatives require accredited investor status—individuals with:

• Annual income exceeding $200,000 ($300,000 for couples)
• Net worth exceeding $1 million (excluding primary residence)
• Professional certifications or credentials

Institutional Investors

Pension funds, endowments, and insurance companies have long used alternatives to:

• Meet long-term liabilities
• Generate stable income
• Preserve capital
• Achieve target returns

Sophisticated Individual Investors

Experienced investors with:

• Substantial portfolios requiring diversification
• Long investment horizons
• Risk tolerance for illiquid investments
• Access to professional advice

Alternative Investment Strategies

Core-Satellite Approach

Build a portfolio with traditional assets at the core and alternatives as satellites:

• 60-80% traditional investments
• 20-40% alternative investments
• Regular rebalancing
• Risk-based allocation

Endowment Model

Emulate successful university endowments:

• High allocation to alternatives (40-60%)
• Emphasis on private markets
• Long-term perspective
• Professional management

Risk Parity

Balance risk across asset classes:

• Equal risk contribution from each asset
• Leverage low-risk assets
• Include alternatives for diversification
• Dynamic rebalancing

The Future of Alternative Investments

Democratization

Technology and regulatory changes are making alternatives more accessible:

• Lower minimum investments
• Improved liquidity options
• Better transparency
• Simplified structures

Innovation

New alternative investment categories continue emerging:

• Impact investments
• Catastrophe bonds
• Life settlements
• Intellectual property
• Carbon credits

Integration

Alternatives are becoming integrated into mainstream portfolios:

• Target-date funds including alternatives
• Robo-advisors offering alternative exposure
• 401(k) plans adding alternative options
• Liquid alternatives in mutual fund wrappers

Conclusion

Alternative investments represent a compelling opportunity for portfolio diversification and potential enhanced returns. While they come with unique challenges—including illiquidity, high fees, and complexity—the benefits can outweigh these drawbacks for suitable investors. Success with alternatives requires careful selection, thorough due diligence, and often professional guidance.

As the investment landscape evolves, alternatives are transitioning from exotic options to essential portfolio components. Whether through direct investment, fund structures, or innovative platforms, investors have more ways than ever to access these non-traditional assets. The key lies in understanding your objectives, risk tolerance, and investment horizon while carefully evaluating each opportunity's merits.

For those willing to navigate the complexity, alternative investments offer paths to returns uncorrelated with traditional markets, protection against inflation, and exposure to unique opportunities. As always, education, patience, and prudent risk management remain the foundations of successful alternative investing.