What are alternative investments? In the simplest terms, alternative investments are anything other than stocks or bonds.
If you’re thinking this is a pretty broad definition, that’s because it is. Within the umbrella of alternatives, there’s a HUGE range of investable assets. If something can be bought and sold, then it could be an investment.
There are some asset classes that are more established than others. People have been investing in real estate, wine, precious metals like gold, and art for a very long time. They’re all still popular asset classes today.
There are also more niche assets too. Vintage cars, music royalties, artifacts, farmland, and LEGO sets are a few examples.
Examples of alternative investments
There are many types of alternative assets, but here are a few popular examples.
Private equity
While private equity has a broad mandate, most investments are into private companies. This can include venture capital investments to technology startups like OpenAI or SpaceX. It can also include buying a controlling stake in something like a hospital.
Private equity provides companies that need to raise funds with options other than an IPO on the public stock market.
As with any investment into a company, these investments carry a lot of risk. It’s entirely possible for a business to fail and be worth little or nothing afterwards. Successful investments have the potential for gains through increased value of the company, or from cash flow from operating profits.
Private credit
Instead of borrowing money from a traditional bank, money is borrowed from investors. Just as with a bank loan, investors will profit from the principal of the loan being fully repaid, with interest.
This provides the borrower with more flexibility. They have greater choices for loans. Investors may also be open to providing loans for assets or with terms that banks would not.
The main risk is that the loans aren’t fully repaid. Perhaps a renovation project didn’t perform as forecasted and the sale didn’t generate enough revenue to repay the entire loan. There’s even some risk of fraud. Just because someone signs an agreement to use funds for a certain purpose, it doesn’t guarantee that they will. That makes diligent underwriting of the loans very important.
Music royalties
This is primarily a yield-based asset class that earns income when copyrighted music is played. This can include when an album is streamed on Spotify or when a song is used in a TV show.
Music royalty investments come with a set amount of time the asset produces income for the investor. This could be something like 10 years. However, it is often for the lifetime of copyright. That lasts for 70 years after the last living artist is deceased - if the music was created after 1978.
As a more unique asset class, it has its own risks. Assets can be difficult to value. Much of artists’ earnings come from streaming platforms. They can always change the rules and calculations for how payments are earned. Lastly, individual artists can get into legal or reputational trouble. That can hurt earnings or the value of their music rights.
Real estate
These investments are in land and buildings. Things like single family homes, office buildings, distribution centers, and apartment buildings.
Real estate investors often seek profits through both yield and appreciation. This comes from renting the property while waiting for it to increase in value over time.
Real estate can be one of the most expensive alternative assets. Loans are typically used for part of the acquisition cost. That leverage can add to potential returns, but it also provides more risk. If market conditions change, a property may no longer generate enough revenue to cover all expenses. That means paying for them out of pocket. On top of that, the reliance on loans makes the market very sensitive to interest rates.
Additionally, it can be difficult and expensive to sell assets. A sale can have closing costs in the neighborhood of 6% and take months to complete. If it's more of a buyers’ market, price cuts and other concessions can eat into sale proceeds as well.
Collectibles
Collectible investments come in many shapes and forms - LEGO sets, baseball cards, vintage cars, rare books, and more. The goal here is to acquire desirable assets that have limited quantities. Investors can profit from appreciation over time.
Generally speaking, these are investments in things. And these things need to be preserved to maintain their value. That means keeping them properly stored, maintained, and possibly insured. That adds a lot of potential costs to the equation.
Beyond that, the markets for collectible goods can be inconsistent. For high-end pieces, liquidity is a challenge. Just because there was one person willing to buy a particular car for $100K, that doesn’t mean it’s easy to find another one. Adding to the potential inconsistency is the fact that these goods often sell through auctions.
Wine
If you’re familiar with the expression “aging like a fine wine,” then you have a jump-start on the investment thesis here. Wine (as well as whisky and spirits) benefits from aging. A bottle of wine that has been properly stored generally has richer flavors.
This makes an older bottle more valuable than a newer bottle. Also, as it ages, there’s less supply of that vintage. Over time, people will gradually consume the wine, which reduces the available supply.
Investors make a profit from being able to resell the wine at a higher price than it cost to buy and age.
As with other alternative investments, there are a variety of risks here as well. Storage and insurance aren’t free, so that will add to the investment cost over time. A failure to maintain proper climate conditions can spoil the wine - and the profits. There’s also a lot of patience required. Some wines enter their peak resale window more than 20 years after bottling.
Risks and challenges
While there’s some exciting potential upside of alternatives, it’s not all sunshine and rainbows. To have a chance to realize the benefits, you also have to stomach the drawbacks.
Liquidity
Traditional investments make this really easy to take for granted. You can sell a stock and in a few days you’ll have the money in your account. In other words, you can basically buy and sell things whenever you want.
Most alternatives don’t work that way at all. Liquidity is instead a major drawback. That can be for a few different reasons.
Sometimes there are rare assets that don’t change hands very often. Art is a good example of this. A painting might be purchased by a collector and held for decades before being sold again. When it comes time to sell something, figuring out the pricing is challenging. There’s not 100 million shares that were traded in the past week to use as a reference.
Even if the asset is priced “correctly,” that doesn’t mean anyone will actually want to buy it at the fair price. The more niche an asset is, the fewer potential buyers there are. That means it can be a long time and a lot of work to actually sell something.
In practice, a lot of investment opportunities are not direct ownership. They’re shares of a fund or a company that owns and manages the assets. That also means they can set the rules too. They decide if or when to sell a building. Maybe they’ll hold it for 3 years, or maybe they’ll hold it for 30. They can also put limitations on redemptions. All of this provides limitations on if, when, and how an investor can get their money back.
Higher fees and costs
The nature of many alternative assets also just makes them more expensive. Remember our wine example from before? That requires a secure, climate-controlled place to store the bottles. You might also want to have insurance to protect the investment as well. All of that has costs.
Additionally, some of the things that create the potential for higher returns, such as active management, also tend to come with fees as well.
A popular fee structure in alternatives is something called two-and-twenty. Under this model, the company offering the investment opportunity charges an annual fee of 2% of the assets under management. They also take a 20% carried interest. This splits the profits between the investor and the investment company after a certain threshold has been reached.
In general, you can also expect to find costs related to legal fees, property management fees, appraisal fees, accounting and tax preparation fees, and more. Often, it is difficult or impossible to invest in alternatives without bearing some of these costs. Real estate is one of the more well-understood alternatives. Even if you invested in a property directly you still face closing costs and property management fees.
All these costs and fees can easily weigh down on investment returns.
Complexity and lack of transparency
Sometimes investments are simple. But oftentimes there are factors that make them more complicated and harder to understand.
That can be due to the nature of the asset class. One example is music royalties, which can be very difficult to properly value. Other times this can be due to the construction of the opportunity itself. There may be many companies involved or complex legal structures may be used to achieve some type of tax or legal advantage.
The disclosure of all of his information is also somewhat Inconsistent.
An individual investment offering is never going to come with a full set of educational content on the asset class. While there may be summary information, it is ultimately up to investors to make sure they know what they’re buying into.
For the complexities involved, disclosure will often be done through very large documents. These can be dozens or hundreds of pages long and filled with complex financial terms and legalese. Summaries are often available, but that will never capture everything you might want to know.
Once an investment has been made, there’s not really any guarantees on what communication you’ll receive. Unlike with public companies, there’s not a quarterly earnings call. Many of these companies have no legal obligations to provide helpful status updates.
Regulatory considerations
Traditional investments come with a fairly robust set of regulatory protections for investors. There are also indirect benefits, such as research firms publishing reports based on companies’ financial disclosures.
There are just a lot less of these in alternatives. There are fewer reporting requirements and less oversight in general. For marketplace transactions - such as directly purchasing a vintage car as an investment - there are no real investment guardrails. That car isn’t going to come with a 100-page set of disclosures about the investment risks.
That may increase the likelihood of bad actors in the space.
There can also be unique tax implications from the legal structures and assets used in some investment opportunities.
Conclusion
From LEGO sets to gold and real estate, alternative investments encompass a wide range of assets outside of stocks and bonds. These asset classes have unique and useful characteristics like less-correlated returns. This can make them useful tools in constructing a diverse portfolio.
However, not all that glitters is gold. There are also new risks and complexities that come alongside them. It’s extremely important that investors do thorough research and due diligence before making an investment. All investments carry risk including the loss of principal, so never invest more than you can afford to lose.
About the author
Josh Heier is a technology professional with nearly a decade of investing experience. Inspired by his parents’ hard work and financial struggles, Josh set out to find a path to less stress and greater financial freedom. His investing journey began in 2016, focusing on alternative asset classes, where high-quality educational resources are often lacking. Determined to fill this gap, Josh launched Asset Scholar, a platform dedicated to helping others learn about diverse asset classes and how to start investing in them. Through Asset Scholar, Josh aims to make investing in alternatives more approachable and accessible for everyone.
