Alternative investments are the fastest-growing segment of the global financial markets. As McKinsey reports on year-end 2011 AUM for global alternatives, they have “grown at a five-year rate of over seven times that of traditional asset classes." The definition of alternative investments is somewhat fluid, but essentially, they’re assets that don’t fall into one of the traditional asset classes, such as stocks, bonds, and cash. Alternative investments include venture capital, private equity, real estate, and crypto.
Why are alternative investments important?
Traditional investment vehicles like stocks and bonds have historically provided investors with a reliable return on their capital over time. However, there’s been increasing doubt surrounding their ability to provide this level of return going forward due to factors like inflation and geopolitical uncertainty.
In fact, trends are shifting to the point where young people are expected to make “dismal returns” in the stock market, as reported by The Economist in 2021. It’s forecasted that Gen Z will only make 2% in global, annualised real returns with a 70-30 blend of equities and bonds. US stocks are expected to barely beat inflation over the next decade according to a 2020 article by Mark Hulbert, and that’s according to the re-adjusted inflation rates (inflation according to the original pre-1980 calculation methodology is far higher).
As such, some investors have turned to alternative investments as a way to gain exposure to superior returns while potentially reducing overall volatility in their portfolios.
What are some examples of alternative assets?
Let’s explore the four main well-established alternative asset markets: venture capital, private equity, real estate, and cryptocurrency.
Venture capital is an investment strategy that involves the provision of financing to promising early-stage companies. This financing can take the form of equity in the company, debt financing, or a combination of both.
Venture capital firms provide start-up companies with much-needed funding to help them grow and expand into new markets. The venture capital industry has grown tremendously over the last few decades. As of early 2020, there are now more than 10,000 angel investor profiles on AngelList, an investor syndicate. Global venture funding is red-hot and currently hitting all-time records in the first half of 2021, with $288 billion invested worldwide.
Private equity refers to investing in companies that aren’t publicly listed on any stock exchange.
Private equity funds invest in firms across multiple stages of their lifecycle—from startup through acquisition or pre-IPO—and aim to acquire stakes in companies with high growth potential.
Real estate is an obvious example of an alternative asset class; however, it can be challenging for individual investors (as opposed to institutional investors) to gain exposure within this space because most real estate deals are done through partnerships or syndicates rather than single transactions.
That said, real estate continues to be one of the most popular alternatives among individual investors because it offers numerous opportunities for diversification across different property types and geographic regions around the globe.
Cryptocurrency has become extremely popular among institutional and individual investors alike, with over 46 million Americans likely to buy crypto next year, according to a 2022 survey from The Ascent. 82% of institutions surveyed from the US, UK, France, Germany, and the UAE are also looking to increase their exposure to crypto into 2023.
How do alternatives compare to traditional assets?
Alternatives generally differ from traditional assets in six main ways:
- They're relatively illiquid
- They have active owners
- They have low correlation to public markets
- They use leverage
- They have high minimum investment requirements
- They’re mainly open to accredited investors
Let’s explore these six key differences in detail.
Alternatives are generally less liquid than traditional assets. This is because they can't be easily bought or sold on the open market. Most private equity and venture capital funds have 10-year terms. If you need liquidity before a fund terminates, you often have to trade them through a broker or another intermediary and be prepared to receive less than fair value. For this reason, investors (rightly) expect to receive a premium return over the public markets when investing in private alternatives.
2. Active owners
The people who create alternatives are active in managing them, unlike with a mutual fund where management is more passive. For example, if you invest in a private company that isn't listed on the stock exchange, you'll often be dealing directly with its founders and managers – not some middleman like a mutual fund manager.
3. Correlation to public markets
Alternatives assets are less correlated to public markets. This means they don’t fluctuate in lockstep when public markets move up or down – which can provide downside protection during bear markets while also providing upside during normal periods.
Private alternative fund managers frequently utilize leverage to purchase ownership stakes in private companies, or to provide growth capital to existing portfolio companies.
Leverage amplifies returns but also amplifies risk – a key factor for both managers and investors. It's important for investors using leverage to understand how much they're investing relative to their available capital.
5. Minimum investment requirements
Most alternatives have high minimum investment requirements. For example, the average minimum investment in a real estate investor syndicate is around $50,000. This is much higher than the average initial investment of $0 to $1,000 required to open a traditional brokerage account. For private equity and venture capital funds, typical minimum investments range from $1 million to $10 million.
Alternative investments often require you to be an accredited investor. An accredited investor is someone who has a net worth of at least $1,000,000 or a constant annual income of at least $200,000 (for individual investors).
This means that the vast majority of people are not eligible to invest in many alternatives.
How is the alternatives industry structured?
The alternatives industry is highly fragmented, with many different players offering a wide variety of services and products.
Investment firms offer both direct investment opportunities in alternative assets (through funds) and indirect access to those assets through private equity vehicles or other investment platforms. Investment consultants advise on portfolio construction, asset allocation, risk management, and other aspects of alternative investments.
Regulatory bodies oversee the industry and set rules for how funds must be structured, managed, audited, and so on. In the US this includes the SEC (Securities Exchange Commission) and FINRA (Financial Industry Regulatory Authority).
Investment platforms connect investors directly with alternative asset managers so that investors can invest more seamlessly through various asset on-ramps.
This eliminates some layers from the traditional financial services food chain which makes investing more accessible to individual investors. With Gridline, investing in more diverse strategies and funds becomes effortless.