Introduction

Other than mainstream investments like stocks, bonds, cash, and gold, there is another type of investment called an Alternative Investment. Alternative investments are those that are not commonly invested in, and some of them even require sophisticated investors like institutional investors or accredited, high-net-worth individuals to operate them due to their high level of complexity and risk. For example, alternative investments such as private equity (PE), real estate, hedge funds, and arts.

Key Takeaways:

• Alternative investments come in many forms and encompass a wide range of assets and strategies.
• Alternatives investments usually behave differently than typical equity and bond investments, adding them to a portfolio may help to reduce volatility, provide broader diversification, and achieve growth.
• Alternative investments are often difficult to value due to their lack of liquidity, which also leads to poor transparency on prices and information. Consequently, alternative investments are associated with a high level of risk.
• In some cases, only accredited investors with significant net worth and experience may invest in the offering.

What is an Alternative Investment?

An alternative investment is a financial asset outside the conventional asset types of equity, bonds, properties, or cash. Alternative investments may involve investing in tangible assets such as precious metals or wine, or in intangible assets such as private equity, private credit, hedge funds and other financial assets. Alternative investments tend to be less correlated with traditional assets and are seen as part of asset allocation options which provide a cushion for investors. Since most alternative investments are not publicly traded, their financial assets tend to have lower liquidity than traditional assets like common equity, bonds and cash investments. The high liquidity risk of alternative investments only allows individuals with extensive asset management or significant funds to participate in such investments. The potential for solid returns has drawn big players like hedge funds and pension funds into the market despite the higher risk and volatility.

Traditional Investments vs. Alternative Investments

An alternative investment is distinct from a traditional investment - the latter refers to investing in stocks, bonds and cash. Meanwhile, alternative investment chiefly employs non-traditional investment strategies. The differences are:

Sources: Mr.Market, BlackRock, PIMCO

Different types of Alternative Investments

Alternative Investments have become increasingly trendy over time. The term “alternatives” encompasses a variety of strategies, each of which has a distinct risk-reward profile and supports a different objective. This article will classify seven types of alternative investments.

1. HEDGE FUND

Hedge funds are investment funds that trade in relatively liquid assets and use various investment strategies in order to achieve a high return on their investment. Hedge fund managers often specialize in a variety of skills to carry out their strategies, such as long-short equity, market neutral, volatility arbitrage, and quantitative strategies.

For instance, managed futures is a trend-following investment strategy that uses quantitative signals to determine when securities are trending. These signals commonly compare the current (spot) price of an asset to the trailing (historical) moving average of the price and then make investment decisions based on those trends. If the spot price is above the moving averages, then the security is in an uptrend, and vice versa.

Read more:

• 5 Common Hedge Fund Strategies Explained
• Hedge Funds vs Mutual Funds: Which is Right for You?

2.PRIVATE EQUITY

Private equity is an extensive field that refers to capital investment in businesses not owned by the public, or those not traded on a public stock exchange, such as the Bursa Malaysia Stock Exchange. The primary private equity investment strategies are leveraged buyouts - when an organisation or one of its units is purchased in full - and venture capital, which focuses on start-ups and early-stage businesses. Private equity firms typically offer more than just funding to the companies they invest in; they also provide advantages like industry expertise, aid with sourcing talent, and mentorship to founders.

2.1 Alternative Credit

Alternative credit is a type of financing given to corporate borrowers or against real estate assets that would be tough to secure in regular, public credit markets. These financings likely necessitate non-standard, customised lending terms and are typically non-liquid, or not simply convertible into cash, so investments in alternative credit strategies are typically longer-term. After the global financial crisis, traditional lenders such as banks looked to reduce risk by revising their lending practices. Alternative credit providers stepped in, filling the gap with different types of direct or private lending, and developing new opportunities for investors. Types of alternative credit investments comprise of direct lending, mezzanine loans, distressed debt, and specialty finance lending.

2.2 Private credit/debt

Private credit refers to investments that are not funded by banks or openly traded. In basic terms, private credit is a non-bank lending activity that covers various forms o debt provided by investors to private organisations. It falls under the category of ‘alternative credit’. Direct lending, mezzanine debt and venture debt are key private credit strategies. Private credit is employed when a company requires extra capital to develop its business. The entities that provide this money are called private debt funds, and they usually earn revenue in two ways: through interest payments and by the reimbursement of the initial loan.

3. REAL ASSETS

3.1 Real Estate

Real estate is the most widely seen type of asset and the biggest asset class in the world. For example, the real estate comprises many types of assets like land, timberland, farmland and intellectual property like paintings. Real estate investments can be direct or indirect, in the public market (e.g., REITs) or privately, and in equity or debt. Real estate has a general tendency to have a low correlation with stocks and is usually regarded as a way to protect against inflation.

Real estate is an unusual category because it has characteristics comparable to bonds—because property owners get current cash flow from occupants paying rent—and equity because the objective is to augment the long-term value of the asset, which is called capital appreciation. It is a type of alternative investment with relatively low liquidity risk and investment risk, but it is also unlikely to have staggering profit potential.

Read more:

• The Ultimate Guide to Real Estate: Everything You Need to Know
• Are Real Estate Investment Trusts Right For You?

3.2 Commodities

Commodities are physical assets, mostly natural resources like agricultural goods, oil, natural gas and rare or useful metals. They act as a hedge against inflation because their value is unaffected by public equity markets. Also, the price of commodities ebbs and flows with supply and demand—a higher demand results in higher prices and, as a consequence, greater investor profits.

It's possible to invest in actual physical commodities or in the companies that produce them, but more commonly, these investments are made using commodity derivatives (futures or swaps). The returns from commodity investing come from changes in the price and don't include an income, like dividends, interest or rent (except for the income earned on the collateral).

4. STRUCTURED PRODUCTS

Structured products are commonly built from fixed-income markets—such as government or corporate bonds that offer investors dividend payments—and derivatives, which are securities whose value stems from an underlying asset or group of assets, for example, stocks, bonds, or market indices. Structured products can be complex and sometimes risky investment products, but offer investors a way to customize their product mix to suit their individual needs. These products are mostly created by investment banks and offered to hedge funds, organisations, or retail investors. Examples of structured products include credit default swaps (CDS) and collateralized debt obligations (CDOs).

5. COLLECTIBLES

Collectibles are a broad category of physical assets that can appreciate in value over time. These assets can include items like rare wines, vintage cars, fine art, mint-condition toys, stamps, coins, and baseball cards. Investing in collectibles means purchasing and maintaining physical items with the hope that the value of the assets will appreciate over time. However, these investments can be risky due to the high costs of acquisition, a lack of dividends or other income until they're sold, and the potential destruction of the assets if they're not stored or cared for properly. The key skill required in collectibles investment is experience. Investors have to be true experts to expect any return on their investment.

6. FUNDS RELATED

6.1 Exchanged-Traded funds (ETFs)

Exchange-Traded funds (ETFs) are open-ended investment funds that are listed and traded on a stock exchange. They are a combination of the features of an Index fund and a stock. The liquidity of an ETF is based on the liquidity of the underlying basket of shares. In general, there are a few types of ETFs, which include equity ETFs, Leveraged & Inverse ETFs, fixed-income ETFs and commodity ETFs. These ETFs are baskets of stocks, bonds, futures or commodities that are based on an index. They offer broad diversification and instantly reduce the risk involved in owning stock of a single company.

Read Also:

• ETFs in Malaysia
• Are ETFs a Good Investment?

6.2 Mutual Funds

Mutual fund is a fund that collects money from many investors and invests it in a variety of asset classes, including stocks, bonds, money markets, and alternative investments, depending on the fund’s mandate. The mutual fund’s combined holdings are called its portfolio. Investors buy shares in mutual funds, with each share representing an investor’s partial ownership in the fund and its income.

Read Also:

• All You Need to Know About Unit Trusts: A Comprehensive Guide For Beginners
• Investing in Unit Trusts in Malaysia: A Step-by-Step Guide

7. OTHERS

7.1 Crowdfunding

Crowdfunding is a means of raising money through the joint effort of friends, family, customers, and private investors. It is typically used by startup companies or businesses in expansion as a way of securing extra funds. It is a creative way of gathering financing for new projects, businesses or concepts. This methodology uses the combined effort of a sizable group of individuals—most often online through social media and crowdfunding websites—and exploits their connections for wider reach and exposure.

7.2 Peer-to-Peer lending (P2P)

Peer-to-peer lending is a type of direct lending where individuals or businesses borrow money from each other without an official financial institution, such as a bank, participating as an intermediary. P2P lending is typically done through online platforms that pair lenders with potential borrowers. P2P lending can offer both secured and unsecured loans, but most of the loans in this industry are unsecured personal loans. Secured loans are less common and are usually supported by luxury assets. Due to its unique characteristics, peer-to-peer lending is seen as an alternative source of financing.

Upsides of Alternative Investments

1. Portfolio diversification

Alternative investments typically have a low correlation with those in standard asset classes, meaning they often move in the opposite direction of the stock and bond markets when market conditions change. This makes them a suitable tool for portfolio diversification.

2. Inflation hedge

Alternative investments such as gold, wine, art and real estate are often promoted as options that can "beat inflation," or generate returns that are above the rate of inflation over a certain period of time without reducing the purchasing power of paper money.

3. Lower Volatility

Alternative investments focus on the strength of each individual investment, rather than relying on general market trends. Therefore, adding alternative investments to a portfolio can potentially reduce overall risk.

4. Enhance returns

Alternatives can improve the risk and return profile of a portfolio and achieve better returns through access to a broader universe of investments and strategies.

Downsides of Alternative Investments

1. Difficult to value

Most alternative investment prices are based on valuations. Valuation is the process of estimating the worth of an asset based on a set of assumptions. Sometimes the issue of poor liquidity of alternative investment products can also lead to inaccurate valuation, and the market may struggle to reflect the true value contained in the alternative investment project in a timely manner.

2. Illiquidity

Alternative investments are not as liquid as traditional investments because they tend to be privately traded instead of publicly traded. They are illiquid, meaning that alternative investments cannot be easily sold or converted to cash. It may take investors a long time to receive returns on their investment, and their money may be tied up for an extended period of time.

3. Lack of regulation and transparency

Most alternative investments are unregulated and do not have to adhere to reporting requirements. For example, collectibles such as wine, whiskey, art, and stamps operate with relatively little regulation and can be opaque. Also, the managers of alternative investments may not divulge information about the holdings of alternative investment products, so the information available to investors is quite limited. Additionally, the underlying assets of alternative investments are often difficult to value, which leads to challenges in pricing and price transparency.

4. High-risk

Alternative investments are often complex instruments that may require a greater level of due diligence. Alternative investments can be more volatile than stocks and bonds, and come with their own unique risks and challenges. They can be highly leveraged, speculative and volatile, an investor could lose all or a substantial amount of their investment. As such, it is important for investors to research and understand the potential tax implications associated with these investments.

The bottom line

Alternative investment is a broad term. Anything that is not a traditional investment vehicle can be considered an alternative investment. Alternative investments are risky and illiquid, so don't get carried away by the potential rewards. The key is always whether you have the tolerance for the risk, and the worst that can happen before you consider alternative investments.

References

• BlackRock. (March 2019). Why should I consider alternative investments?
• BlackRock. (March 2019). What are alternative investments?
• James Chen. (February 2022). What Are Alternative Investments? Definition and Examples.
• CFA Institute. Introduction to Alternative Investments.
• Natalie Chladek. (May 2020). 7 types of alternative investments everyone should know.
• Stephen Yong. (February 2021). Alternative Investments for Individual Investors.
• Daljit Dhesi. (Jun 2021). Opportunities in alternative investments.
• Mr.Market市場先生. (Jun 2021). 另類投資是什麼？為什麼要進行另類投資?.
• Jack Caporal. (Jan 2022). Are Alternative Investments the Best Inflation Hedge? Here's the Data.
• PIMCO. (April 2021). Understanding Alternative Investments.
• Craig Franklin. (Jun 2022). Understanding The Pros And Cons Of Alternative Investments.
• AGF Management. What is Private Credit?
• PIMCO. (2020). Alternative Credit: Answers to Investor Questions on Market Volatility.
• Charles Schwab Investment Management. What is an ETF
• U.S. Securities And Exchange Commission. Mutual funds.
• MyPF Services PLT. Alternative Investments.

Author

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This article is written by Lim Wuan Chin, Research Analyst Intern

Lim Wuan Chin is currently majoring in Finance and Investment at Tunku Abdul Rahman University of Management and Technology (TAR UMT). Wuan Chin joined TED Optimus Sdn Bhd for 3 months as a research analyst intern. She has participated in Bursa Malaysia Derivatives Virtual Trading Challenge 2021. She is an in-house author from TED Optimus.