What are my Alternatives within "Alternative" Investments?
Don't be put off by "alternative" investments.
Most individual investors have either read about "alternatives" or have been told by a financial adviser at some point that this is an asset class that they need to include in their portfolio, but the reality is that many people simply don't know what to do with this advice. For a few, "alternatives" is at best an afterthought. For many others, "alternatives" can be dauntingly confusing and conjure images of exotic investments more suitable for savvy institutional investors
From my personal experience, I believe all investors can successfully incorporate alternative investments into their portfolio and the key is to start by understanding the basics.
First things first...what are "alternatives" anyway?
Are we talking about gold, or oil, or perhaps even something more exotic like art or rare coins? Well, it can certainly be any or all of those things. According to Investopedia, "alternatives" are simply defined as any investments outside of the three traditional asset types - stocks, bonds, and cash, so there's certainly a broad range of assets that can fit the bill, many of which are already familiar to most investors even if they've not proactively looked to invest in them.
Why should you include "alternatives"?
Savvy investors typically look to include alternative investments for several reasons:
- Improve diversification by reducing correlation with publicly traded securities. There's a lot of empirical research around this but the simple summary is that the more an asset is not correlated with the stock market, the better the chance one would have to achieve more consistent returns in any market condition.
- Achieve higher absolute returns with potentially better risk/reward characteristics. Some alternative investments may provide opportunities for exceptional returns at lower risk, though in many cases there may be significant trade-offs such as less liquidity in the case of real estate or venture capital/hedge fund investments
- Incorporate highly specialized strategies into a portfolio. This could be something as simple as wanting a vehicle that focuses on derivatives or commodities to more sophisticated strategies designed to enhance yield/income through structured investments such as reverse convertible notes
- Leverage specialized investments related to their profession for which they have unique insight into. An example of this is a friend of mine who is a very accomplished professional musician. He owns very expensive musical instruments (6 to 7 figures in value) that not only serve as tools for his profession, but are also investments that he has unique expertise in. In fact, as he gains in fame, the very fact that he uses an instrument can increase its value.
For most everyday investors, clearly not all of the above will apply and I think the most obvious benefit of alternatives is that of diversification. Additionally, there can be a secondary psychological benefit that can impact your financial results as well. For me, I've found that by specifically designating a portion of my portfolio for taking greater risk (or less conventional risks), I've been able to stay more focused and avoid the temptation to stray from my core strategies to chase returns in the rest of my portfolio.
How much should I have in "alternatives"?
As is often the case in investments, the answer is it depends. The general rule of thumb that I've personally applied is to have no more than 10% of my liquid net worth in alternative investments (excluding a primary residence which would technically be an alternative and obviously skew the allocation). This percentage can certainly vary for each person depending on the objective of your portfolio, appetite for risk, etc (see my Investment 101 article for some related general advice). Another key determinant of your allocation should also be your level of comfort with and knowledge of alternative investments, which is something that one builds over time. So if you are just starting out, I would advocate having a lesser allocation to this asset class than to rigidly keep to some set formula and blindly select investments to meet the "alternative" definition.
Lastly, I would also point out that the ability to include alternatives in your portfolio changes with portfolio size. That is, smaller portfolios may be precluded from certain types of investments such as real estate, simply because of the minimum required investment may overly skew your allocation percentage.
So what are my options for investing in alternatives as an individual investor?
This is the key question that I've often been asked and the impetus for writing this article. While average individual investors won't have the same level of access to the full range of alternative investments as institutions and more savvy investors, I do believe that with some work and creative thinking, individual investors can find good options in today's market, even in areas that used to be accessible only to institutional investors or ultra high net worth individuals.
Here's a few to consider (note - these are not investment recommendations, merely my personal opinions of where you could look for potential alternative investment ideas):
Gold can be a great hedge for down economies or a declining dollar and has always been popular as a store of value since the beginning of civilization (e.g. the gold standard). The same can also apply to other precious metals such as Silver and Platinum, although the market value of other metals may experience different fluctuations due to changes in supply/demand, especially if it is useful for commercial applications.
There are numerous ways to invest in gold. Some people like to own physical gold, in the form of numismatic coins, bullion coins, or bullion bars. These can be purchased from the U.S. Mint or through private dealers such as Monex and Kitco. But one issue to note is storage which can be an expensive added cost, especially if it's at a secure offsite facility such as a Swiss vault. BullionVault is another option that provides you with a one stop shop solution to buying, storing, and selling your physical gold with minimum costs.
Another way is through Exchange Traded Funds (ETFs) such as GLD and IAU for gold or SLV for Silver and PTM for Platinum. Shares in ETFs are not physical holdings of gold since you cannot redeem them for physical delivery but rather shares that are backed by gold (typically tracking spot prices, bullion prices, etc.). While ETFs are convenient and liquid, there are some tax issues (taxed as a collectible at flat 28%) and some drawbacks around the quality of these instruments as pure investments in gold (see article here).
Other ways to invest in gold include futures, forwards, options, certificates, accounts, shares in funds like CEF and PHYS, and shares of gold mining companies which are generally correlated to gold's value but are also affected by the health of the companies. In general, it is important to note before you invest in these that the more exotic the instrument (e.g. futures), the higher the knowledge required and the potential risk. While no instrument is perfect, at the end of the day, the good news is that options exist for you to choose the investment that best meet your objectives and criteria.
Closely related to precious metals are investments in commodities (in fact precious metals are a type of commodity). These generally include basic resources and materials that are fungible and undifferentiated such as sugar, rice, soybeans, oil, corn, pork bellies, etc.
Since commodities trading can be a bit more complex - requiring setting up an account with a commodities broker and dealing with futures and options contracts, a simpler way for most investors would be ETFs which are easily accessible from any brokerage account. Like precious metals, there are a wide range of varieties for single commodities, a basket of commodities, long bets, and short bets so there should be one for you regardless of your outlook or preference.
Despite being the largest financial market in the world, investing in currencies through Forex trading has traditionally been the domain of large institutions and savvy investors, for good reason. In addition to having to set up accounts to trade with retail FX dealers, there's a lot less regulation and lots of new things that an investor would have to learn - from specialized jargon to new facts like the available currency pairs for trading. So to keep it simple for individual investors, I would again advocate the use of ETFs, which has the advantage of not limiting you only to certain currency pairs that are traded on FX. So if you are bullish on the appreciation of a particular currency, you could buy an ETF denominated in USD, thereby profiting if the currency does appreciate and you are able to sell the ETF later for a higher USD price. An example of a currency ETF is CYB, the Chinese Yuan Fund which I'm a fan of (see my article on Profiting from the Rise of China) - despite being a nonconvertible currency, the Chinese RMB does periodically adjust and is in my opinion a very safe way to participate in the growth of China.
Another way to invest in currencies is to open an account with a bank that allows you to hold foreign currencies, such as Everbank or HSBC, which would give you the most direct pure play opportunity in another currency short of traveling to another country and opening an account there in person (certainly also an option).
Private Equity and Venture Capital
Typically, this type of investment has only been available to accredited investors who are individuals with over $1M in net worth or over $200K in annual income and it comes with high minimum investment thresholds and long required holding periods.
While that's certainly still the case for pure play investments as a Limited Partner (LP) in these funds, individual investors now have some alternatives if they are seeking some private equity and venture capital exposure. On the private equity side, individual investors can now choose from publicly traded private equity firms such as KKR (KFN), Blackstone (BX), Apollo (AINV), and American Capital (ACAS). On the venture capital side, meVC led the way to publicly traded VC firms and investor today can buy shares in companies such as Harris & Harris (TINY) if they wish to share in the risk and return of backing small private companies. While these are technically still stock investments, I consider them good proxies for alternatives given that they are companies that generate their returns from direct investments in private equity and venture capital and they have the benefit of being liquid and not requiring a minimum investment.
Note that I'm not necessarily endorsing any of the above as good investments in the absolute. Just as with any investment, a potential investor would have to do the homework to assess the quality of these investments for themselves.
Another rather intriguing option that has emerged in recent years is SharesPost which is an innovative startup that has created a market place and community for individuals to buy and sell shares in private companies. While only accredited investors can be buyers, what's interesting is that an investor can choose the specific private companies to invest in, as opposed to being a limited partner in a venture fund where they have no say in the investment choices. One major downside of these types of investments however, is the lack of transparency. Unlike public stock where there's an abundant of information on the company's financials or enterprise valuation, investors are generally operating with a lot of information asymmetry so even if you do your homework, there's still a good chance that you could overpay for the stock of a private company.
Despite all of the problems we've seen in US, real estate is certainly still a large and important type of alternative investment. In fact, real estate investments like timberland are often cited as one of the key drivers of the market-beating returns that many University endowment funds have experienced in the past decade. For the individual investor, options abound for this type of investment, ranging from land, REITs (real estate investment trusts), specialized bonds like mortgage backed securities, as well as rental property and commercial property, just to name a few. However, generally speaking, most people likely won't have many options in this category until the portfolio reaches a certain size.
I've also found that real estate is often the one investment type that can be very emotional for some people, so I would emphasize the importance of making a mental separation between the real estate you include as an investment in your portfolio vs. those that you buy for personal enjoyment. A good example is timeshare. Timeshare sale reps will often tout these as both personal enjoyment and good investments. The reality however, which is easily verifiable by looking at the secondary market listings of timeshares, is that most timeshares are not high appreciating assets and should really be thought of as simply a different kind of vacation expense.
More Exotic Alternatives
As I mentioned in the outset, there can be many other things that could classify as an alternative - art, musical instruments, exotic or rare automobiles, stamp collections, etc. etc. A key consideration of these other types of investments is the extent to which they are liquid. The more specialized and exclusive the investment, the smaller the market and lower likelihood that you will have ready access to a market for trading that asset, despite its paper value.
Do Good While Investing
For some people, investing is purely about generating returns and seeking "alpha" (excess returns vs. risk taken).
But increasingly, many folks are seeking something more. To them, investing can be another form of expressing one's values and I personally believe that there are many ways in which one can both achieve financial goals and do good for society at the same time.
A classic example of this is social/ethical investing. A social investor would choose to limit their investments only to companies who promote certain values in their corporate practices, such as human rights in emerging countries. Or, they may choose only to invest in companies that create socially acceptable/responsible products (e.g. avoid companies that sell Alcohol, Tobacco, etc.). But there are trade-offs to this approach, such as a narrower band of options for portfolio diversification. And still for others, simply limiting investments may still be too passive in nature for individuals who want to have more active impact on social causes.
In recent years however, another creative option that has emerged is peer-to-peer lending which I've been following with great interest. I believe that this new form of investing can provide a direct outlet to do social good as well as offer individual investors another way to invest in "alternatives".
Two companies that have been the innovators in peer-to-peer lending are Prosper.com and Kiva.com and I'll focus the rest of this article on an overview and brief review of their different models/offerings.
1. Prosper.com - Prosper bills itself as "America's largest peer-to-peer lending marketplace". The website essentially enables anyone who registers as a lender to make unsecured loans to individuals for specific needs. The types of causes you can support range from helping deserving/needy folks with debt consolidation to supporting people with educational or medical needs. Depending on the risk profile and credit worthiness of the individual you are investing in, you get an investment return commensurate with the risk you are taking (though there is always risk of default). The process for getting started is pretty simple - it only takes a few minutes to register by entering basic personal information to establish a profile and attest to your financial suitability, you'll be ready to begin lending. For people who are interested in seeing how their money directly affects others, this is a great way to get some personal satisfaction out of lending, while at the same time potentially getting superior returns. The only caveat here is that given the default risk that exists with any loan, the best way to lend in this format in my opinion is to take a portfolio approach and spread your bets across numerous lending opportunities so that your returns will cover any defaults.
2. Kiva.com - There are several key differences between Kiva and Prosper. The first is that Kiva is global with focus on developing countries, whereas Prosper is strictly US-focused. The second is that with Kiva, you are not dealing directly with individuals but rather contributing to a microfinance organization acting as a local intermediary who aggregate funds from numerous contributors to support a specific cause or project that you are lending to. Lastly, the biggest difference here is that unlike Prosper, Kiva is not an investment. Lenders do not receive interest for their loans (and may actually lose depending on the repayment), although the field partners do charge interest as a means to maximize self sustainability of the system.
To net it out, I've been personally intrigued with this model and have started to experiment with it myself. At the end of the day, neither will be a good vehicle for generating huge returns on large sums of money. However, if you are looking to get some above average returns for small sums of money, prosper can be a potentially interesting way. For those who want to help the poorest and most needy in the developing world, Kiva offers a great way to "teach a man how to fish" rather than just "giving him a fish". While it generate no actual investment returns (since there's no interest), the social benefit you provide can be far more rewarding.