Alternative investments have become increasingly popular in America over the past decade. Investors are looking beyond just stocks and bonds to diversify their portfolios. Some of the most common alternative investments pursued by American investors include private equity, venture capital, hedge funds, real estate, commodities, and collectibles. The volatility of the stock market and low yields on bonds have driven the growth of alternatives. Americans now have over $13 trillion invested in alternative assets. However, these investments come with more complexity, illiquidity, and fees. Proper due diligence is required before investing. This article will provide an overview of the major alternative investment categories American investors should understand.
Private Equity Fuels Business Growth but Carries High Risk
Private equity refers to investments in private companies not listed on public exchanges. Investors can buy shares directly or invest through a fund. Private equity helps provide funding for small businesses to grow. Top U.S. private equity firms like Blackstone, Carlyle Group, and KKR have raised billions for acquisitions and expansion. However, private equity investments are illiquid, risky, and require large minimums. The typical fund life is 10-12 years during which investors cannot access their capital. These investments should only make up a small allocation for accredited investors. Industry data shows private equity returns are highly variable year-to-year but have exceeded public markets over the long-term.
Venture Capital Drives Innovation yet Expect High Failure Rates
Venture capital provides start-up funding for emerging companies in exchange for an equity stake. Over $130 billion was invested in U.S. startups by VCs in 2019. The potential returns are enormous but so is the risk. VC funds invest in dozens of small companies knowing most will fail. However, a few winners can deliver outsized returns. For example, a16z made billions investing early in companies like Facebook, Twitter, Lyft and many lesser known tech firms. But without access to the top-tier VC funds, returns are much more inconsistent. Retail investors should stick to indirect exposure through public companies that benefit from VC spending.
Real Estate Remains a Core Holding for Income and Diversification
Real estate is a popular alternative investment for Americans due to its income generation and diversification benefits. The most accessible options are REITs and real estate crowdfunding platforms. REITs provide exposure to portfolios of properties and trade like stocks. Crowdfunding allows investors to buy shares of individual properties online. Rental income can provide steady cash flow while price appreciation over time increases the investment value. Real estate also has a low correlation to stocks and bonds. But there are risks like tenant turnover, maintenance costs and falling property values in down markets. Overall, real estate should form part of a balanced portfolio for most investors.
Commodities Protect Against Inflation but Add Volatility
Commodities like oil, metals, livestock, and agricultural products provide an inflation hedge that stocks and bonds lack. Major commodity indexes have generated comparable long-term returns to equities with less severe drawdowns during crisis periods. But commodities come with higher volatility. Retail investors generally access commodities through ETFs tracking major commodity indexes. But the contango structure of futures-based commodity ETFs can reduce returns over time. Actively managed commodity funds with dynamic rolling strategies can mitigate these effects. Commodities have a place in portfolios as an uncorrelated asset class but should be sized appropriately given the volatility.
Hedge Funds Can Enhance Returns for Qualified Investors
Hedge funds use alternative strategies like shorting, leverage, and derivatives to generate market-beating returns. The top performers have delivered high risk-adjusted returns over time. However, many others fail to outperform basic index funds after accounting for their extremely high fees. Hedge funds are only open to accredited investors and require lock-up periods. Fund of funds provide easier access but add another layer of fees. Proper due diligence into a hedge fund’s strategy, risk management, and track record is essential given the wide dispersion in performance and lack of regulation. Allocations should be limited for qualified investors seeking enhanced absolute returns.
Alternative investments like private equity, venture capital, real estate, commodities, and hedge funds can enhance portfolio diversification and returns for American investors. However, these come with much higher fees, complexity, and risks that require thorough due diligence. Alternative investments should be a limited allocation focused on the investor’s specific goals like income, inflation protection, or absolute returns.