Unlocking the Secret to Successful Alternative Investing Strategies

Alternative investing has long been associated with large institutional investors and complex investment strategies. However, recent regulatory changes have made this asset class more accessible to a broader audience, offering a range of benefits that are often overlooked.

From precious metals and oil and gas to venture capital and real estate, alternative investments encompass a diverse range of opportunities. In this article, we will explore the advantages of investing in alternative assets and why they should be a crucial part of every investor’s portfolio.

Why Invest in Alternative Assets?

If we compare the investment allocations of institutional investors to those of individual investors, a significant disparity becomes apparent. Institutional investors allocate up to 30% of their portfolios to assets other than stocks, bonds, and mutual funds.

These assets can include real estate, venture capital, and hedge funds. In contrast, the average individual investor puts 95% of their money into the stock market. This discrepancy highlights the knowledge gap between institutional and individual investors when it comes to alternative investments.

One notable example is the Yale Endowment fund, which has consistently outperformed the stock market by a significant margin. By diversifying their investments into alternative assets such as hedge funds, real estate, and timber, Yale’s endowment grew from $1.3 billion in 1985 to a staggering $31.2 billion in 2020. This remarkable success story demonstrates the potential of alternative investments to generate superior returns.

The question then arises: why aren’t regular investors taking advantage of these opportunities? Historically, individual investors had limited access to private investments outside of the public markets.

However, with the passing of the Jobs Act in 2012, accredited investors gained access to private investments previously reserved for larger family offices and institutional investors. This regulatory change has opened up new avenues for individual investors, offering significant potential upside.

Understanding Different Types of Alternative Investments

Alternative investments serve as alternatives to traditional stocks, bonds, and mutual funds commonly offered on Wall Street. The most common types of alternative investments include hedge funds, private equity, venture capital, oil and gas, and real estate. Some even extend the definition to include gems and precious metals, art and antiques, and collectibles. Let’s explore each of these broad categories in more detail:

Hedge Funds

Hedge funds employ various investment strategies and typically focus on publicly traded securities. Their goal is to generate returns in both up and down markets by leveraging their specific strategies. While hedge funds offer diversification and potentially attractive returns, they may not be the ideal choice for most investors.

Venture Capital

Venture capital firms invest equity in privately-owned companies, particularly those in the early-stage or start-up phase. The aim is to support these companies’ rapid growth and eventual exit through acquisition or an Initial Public Offering (IPO). Venture capital investments require a higher risk tolerance and active involvement in managing the investment.

Private Equity

Private equity is a broad category that encompasses all private investments except venture capital. Fund managers in this class invest in various asset types, including real estate, infrastructure, oil and gas, and debt. Private equity investments often aim to acquire controlling interests in operating businesses.

While hedge funds and venture capital investments have their advantages, private equity alternatives offer the greatest potential for most investors. Private equity alternatives help bridge the gap in portfolios, providing an array of benefits that we will explore in the following sections.

The Advantages of Investing in Alternative Assets

1. Uncorrelated to the Stock Market

One of the primary reasons investors seek alternative investments is diversification. Public investments such as stocks and bonds are subject to the unpredictable swings of the stock market. Alternative investments, on the other hand, offer the potential for uncorrelated returns. For example, real estate investments, such as mortgage notes or rental properties, provide a steady income stream regardless of stock market volatility.

2. Lack of Volatility

Traditional public investments often experience significant price fluctuations unrelated to a company’s performance. In contrast, private investments are not publicly traded, reducing the volatility associated with public investments. Moreover, private investments are typically backed by tangible assets, providing additional security. By minimizing volatility, alternative investments empower investors to benefit from the power of compounding over the long term.

3. Direct Ownership

Unlike many public investments where investors hold paper assets, alternative investments often involve direct ownership. Whether it’s fine wine, art, rental properties, mortgage notes, or private funds, investors have a tangible stake in the underlying assets. This direct ownership provides a sense of control and allows investors to diversify their portfolios beyond traditional investments.

4. Direct Tax Benefits

Alternative investments can offer compelling tax benefits. Many private alternative investments, such as real estate funds, utilize pass-through structures, allowing investors to benefit directly from tax advantages. For instance, real estate funds often deduct depreciation expenses, reducing taxable income. Additionally, certain alternative investments can be made using qualified retirement funds, enabling tax-deferred or tax-free growth.

5. Strong Income Potential

While not all alternative investments generate cash flow, many cash-flowing strategies exist within the alternative asset space. Cash-flowing real estate investments, for example, can provide annual returns in the range of 8-10%. This income stream can be particularly appealing for investors seeking additional sources of income or looking to replace earned income or retirement income.

6. Passive Investments

Many investors value their time and prefer passive investment opportunities that minimize the need for active management. Alternative investments cater to this preference, offering passive investment options that leverage the expertise of experienced operators. For instance, private equity funds or syndications provide passive investors with the opportunity to benefit from the knowledge and relationships of skilled professionals.

Despite the numerous advantages, alternative investments do have a few drawbacks. Liquidity is a common concern, as many private investments have lockup periods ranging from 3-10 years. However, certain classes of alternative investments, such as note investing, offer more liquidity through an active secondary market. Another limitation is the requirement for investors to be accredited, although regulatory changes have expanded access to non-accredited investors.

Who Should Consider Alternative Investments?

Alternative investments can be a suitable addition to any investor’s portfolio, offering diversification and potential for superior returns. The suitability of different alternative investing strategies depends on an individual’s investment goals and level of involvement. Here are some scenarios where alternative investments may be particularly advantageous:

1. Active Investors

Active investors who are willing to actively manage their investments may find alternative assets such as rental properties, house flipping, and private equity appealing. These strategies require hands-on involvement and offer the potential for higher returns.

2. Passive Investors

For those who prefer a more hands-off approach, alternative investments can still deliver strong returns without the need for additional time commitment. Passive investors can explore opportunities in private equity, mortgage note funds, collectibles, and precious metals.

3. Retired or Income-Focused Investors

Retired individuals or those seeking income-focused investments can benefit from the low-volatility income streams provided by alternative assets. Private equity funds, private REITs, and private real estate funds are examples of alternative investments that can help supplement or replace earned or retirement income.

Conclusion

Alternative investing offers a world of opportunities beyond traditional stocks, bonds, and mutual funds. With the potential for uncorrelated returns, lower volatility, direct ownership, tax benefits, strong income potential, and passive investment options, alternative assets are an essential consideration for all investors.

By diversifying their portfolios and capitalizing on the advantages of alternative investments, investors can potentially achieve superior long-term returns. Whether you are an active investor looking for higher-risk strategies or a passive investor seeking steady income, exploring the world of alternative investments can open up a new realm of possibilities for your financial future.