Alternative Investments Explained: Private Equity, Hedge Funds and More

Alternative investments are assets outside the traditional categories of stocks, bonds and cash. They’ve long been popular among wealthy investors, endowments and pension funds, and they’ve become increasingly accessible to individual investors in recent years. Alternatives can offer diversification and unique opportunities, but they also come with distinct risks, costs and complexities that every investor should understand.

Common types of alternative investments

Private equity involves ownership in private companies that aren’t traded on public stock exchanges. Private equity funds typically buy companies, work to improve their operations and profitability over several years and then sell them, aiming for significant returns. Investments in private equity funds often have long time horizons, commonly a decade or more.

Venture capital involves investments in early-stage startups with high growth potential. Venture capital can produce large returns when a startup succeeds, but many startups fail, making it very risky.

Hedge funds are pooled investment funds that use a wide range of strategies, which may include short selling, leverage, derivatives and trading across many asset classes. Hedge funds vary enormously in their strategies, risk levels and performance.

Private credit involves loans made to companies outside traditional banks, often by specialized funds. Private credit has grown significantly in recent years, offering potentially higher yields than traditional bonds, along with greater credit risk and less liquidity.

Real assets include real estate, infrastructure, such as toll roads, energy facilities and airports, and commodities, such as gold, oil and agricultural products. Real assets may provide income and potential protection against inflation.

Collectibles include art, wine, classic cars, rare coins, watches and other tangible items valued for rarity and demand.

Some definitions also include digital assets, such as cryptocurrencies, among alternatives.

Potential benefits

Some alternatives may behave differently than stocks and bonds, which can add diversification to a portfolio. When traditional investments decline, certain alternatives may hold their value or move independently, potentially reducing overall portfolio volatility, though this isn’t guaranteed and correlations can change, especially during market crises.

Some alternatives offer the potential for higher returns, particularly private equity and venture capital, though higher potential returns come with higher risk, and returns are never guaranteed.

Alternatives can also provide access to opportunities not available in public markets, such as investing in private companies before they go public.

Certain alternatives, like real estate and infrastructure, may provide steady income streams.

Risks and drawbacks

Illiquidity is one of the most significant drawbacks. Money in many alternative investments may be locked up for years, and you may not be able to withdraw it when you want. Private equity funds, for example, often require commitments of a decade or more. Even investments that allow withdrawals may limit how much and how often you can redeem.

High fees are common. Many alternative funds charge both management fees, often a percentage of assets annually, and performance fees, a share of profits, sometimes described as two and twenty. These fees can significantly reduce net returns.

Less transparency and regulation apply to many alternatives. Private funds generally aren’t required to provide the same level of disclosure as publicly traded investments or registered funds, making it harder to evaluate holdings, risks and performance.

High minimums and accredited investor requirements limit access. Many private alternative investments are available only to accredited investors, who must meet income or net worth thresholds set by the SEC, and may require minimum investments of hundreds of thousands of dollars or more.

Hard-to-value assets make it difficult to know an investment’s true worth. Private assets aren’t priced daily by markets, so valuations may be based on estimates that can lag reality and smooth out apparent volatility.

Complexity can make it hard to fully understand the risks, strategies and terms of alternative investments.

Newer access for individual investors

Some alternatives are now offered through registered funds, such as interval funds, tender offer funds and non-traded real estate investment trusts, with lower minimums and fewer eligibility requirements. Publicly traded options, like REITs and certain ETFs, also provide exposure to some alternative asset classes with daily liquidity.

If you consider these products, read the prospectus carefully, especially sections about fees, redemption limits, valuation methods and risks. Some products that offer periodic liquidity may limit or suspend withdrawals during periods of market stress.

How much, if any, to allocate

There’s no single right amount to invest in alternatives. Large institutions sometimes allocate significant portions of their portfolios to alternatives, but individual investors have different needs, especially for liquidity. Many advisers suggest that alternatives, if used at all, make up a modest portion of a portfolio, with the majority in diversified traditional investments.

Keep perspective

Many successful investors build substantial wealth with simple, low-cost, diversified portfolios of stocks and bonds. Alternatives are optional, not required, for building wealth. If you’re considering alternatives, a fee-only fiduciary adviser can help you evaluate whether they fit your goals, risk tolerance and liquidity needs.

This article is for education only and isn’t investment advice.