What Are Alternative Investments, and Do They Belong in My Portfolio?

By Markets Fool.com


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Most investors hold a combination of stocks, bonds, and cash in their investment portfolios, some using individual securities while others use exchange-traded funds or mutual funds to set up their asset allocations. Increasingly, though, many investors are turning to alternative investments to try to improve their returns. Alternative investments include investing vehicles that are typically open only to high net worth individuals and institutional investors, such as hedge funds and private equity funds. Other alternative investments are somewhat esoteric, including managed futures funds and derivative contracts. However, many people refer to alternative investments as including anything beyond stocks and bonds, with real estate, gold, and other commodities being some of the most common assets in that class. Alternative investments can give you greater diversification and improve your risk-reward profile, but they also require getting expertise to understand them.

Access to alternative investments

Sometimes, it's difficult even to invest in alternative investments. Hedge funds and private equity funds are typically subject to rules restricting purchase to accredited investors, which means either an institutional investor or an individual who meets the accreditation requirements. Current rules require that an accredited investor who is an individual person have a net worth of $1 million or more, excluding any primary residence, or have income of at least $200,000 in each of the two most recent years. If the person is married, then combined net worth of $1 million is adequate, but joint income of $300,000 is necessary for the income rule.

In order to make alternative assets more accessible, some mutual funds invest in hedge funds, venture capital funds, and private equity funds. Because the fund is the direct investor, it can qualify to invest, and accredited investors rules don't apply to the mutual fund shareholders.

Other alternative investments are easier to buy but still require special treatment. Most investors trade commodities using futures contracts, which require either a separate futures trading account or an expanded brokerage arrangement with your existing broker. Exposure to real estate and gold is available through funds as well, but you might prefer to hold physical gold or to buy specific real property, and you have to work through specialists to do so.

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Are alternative investments smart?

Ideally, the best alternative investments would be those that have solid returns that aren't correlated to the stock and bond markets, because they would provide the most diversification. Unfortunately, the performance of alternative investments doesn't always live up to their potential.

Hedge funds, for instance, have gone through extensive periods of underperforming the stock market, and strategies that once worked well have suffered setbacks. Real estate remains popular, but prices have risen to the point at which income available from real estate is lower than in the past. Commodities investments tend to be cyclical, and the drop in construction and infrastructure activity worldwide has hurt commodity prices in recent years.

In addition, some alternative investment providers take advantage of the lack of understanding among investors. Regulatory concerns have led to a clampdown on potential fraud and other less than transparent investment vehicles, but you still have to be on your guard in evaluating alternative investments.

Used correctly, alternative investments can be useful in managing risk and maximizing return. However, they're more complex and require more attention than many investors are willing to give. If you want to benefit from alternative investments, you need to commit to understanding them fully and weeding out poor options to find the best fit for your portfolio.

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