Alternative investments refer to assets and strategies outside of traditional long-only stocks and bonds investments. They include hedge funds, private equity, venture capital, real estate, commodities, infrastructure etc. Alternative investments usually have lower correlation with traditional investments, which can provide diversification benefits. However, they also have disadvantages like higher fees, lower liquidity, less regulation and transparency. In this article, we will analyze the pros and cons of alternative investments versus traditional investments.
Alternative investments have wider investment opportunities
Compared to traditional investments limited to public traded stocks and bonds, alternative investments open door to more asset classes like private companies, real estate, infrastructure, commodities etc. This provides investors more opportunities to seek alpha and diversify their portfolios. With skillful active management, some alternative investment strategies can generate higher returns than passive indexing of traditional assets.
Alternative investments have diversification benefits
Alternative investments like hedge funds, private equity and real estate tend to have lower correlation of returns with traditional stock and bond markets. Adding alternative investments to a portfolio can reduce overall volatility and provide better risk-adjusted returns. During times of crisis when stock and bond markets decline significantly, some alternative investments may hold up better.
Alternative investments have higher fees
Alternative investment funds typically charge higher management fees, in the range of 1-2% of assets under management, versus less than 0.5% for traditional mutual funds and ETFs. There are also performance fees up to 20% of profits for hedge funds and private equity funds. The higher fees eat into net returns for investors.
Alternative investments are less liquid
Many alternative investments like private equity and real estate funds have multi-year lockup periods where investors cannot withdraw their money. Hedge funds often have lockups of 1 year or more. This compares to daily liquidity for stocks and ETFs. The lower liquidity makes alternative investments unsuitable for investors who need ready access to their capital.
Alternative investments have less transparency
Alternative investments do not have the same level of reporting and disclosures as traditional publicly traded stocks and bonds. There is less transparency into their investment strategies, positions, and performance. Investors have to rely more on the fund managers for proper risk management and governance.
Alternative investments have pros like wider opportunities and diversification versus traditional investments, but also have cons such as higher fees, lower liquidity and transparency. Investors should weigh these factors carefully when allocating to alternative investments.