How to Invest: Alternative Investments

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Welcome to How to Invest. In this article:

• Main Feature: Alternative Investments: Beyond Stocks and Bonds

• Investment Ideas for All Budgets

• Educational Corner: Understanding Correlation in Portfolio Construction

• Did You Know? A Quick Financial Fact

Alternative Investments: Beyond Stocks and Bonds

Alternative investments encompass a diverse range of assets outside traditional stocks, bonds, and cash. These investments typically feature different risk-return profiles, unique market dynamics, and potentially lower correlation with conventional financial markets. While traditional investments form the foundation of most portfolios, alternatives can provide diversification benefits, inflation protection, and access to specialized opportunities not available in public markets. This section explores various alternative asset classes, their distinctive characteristics, potential benefits, and important considerations for incorporating them into a diversified investment strategy.

Types of Alternative Investments

The alternative investment universe includes several major categories:

• Commodities: Physical goods like precious metals (gold, silver, platinum), energy products (oil, natural gas), agricultural products (corn, wheat, coffee), and industrial metals (copper, aluminum). These tangible assets often respond to supply-demand dynamics distinct from financial markets.

• Real Assets: Tangible investments beyond traditional real estate, including infrastructure (toll roads, airports, utilities), timberland, farmland, and natural resources. These assets typically generate income while providing exposure to essential physical components of the economy.

• Private Equity: Investment in private companies not listed on public exchanges, including venture capital (early-stage companies), growth equity (expanding businesses), and buyouts (mature companies). Private equity offers potential for higher returns in exchange for long-term capital commitments and illiquidity.

• Hedge Funds: Actively managed investment pools employing various strategies including long-short equity, global macro, event-driven, and quantitative approaches. These funds aim to generate returns with lower correlation to broader markets, often using leverage, derivatives, and short-selling.

• Collectibles: Tangible items valued for their rarity, condition, historical significance, or cultural importance, including fine art, wine, classic cars, watches, rare coins, and sports memorabilia. These passion investments combine potential appreciation with non-financial benefits.

• Cryptocurrencies: Digital assets based on blockchain technology, including Bitcoin, Ethereum, and numerous altcoins. This emerging asset class offers exposure to financial innovation and potential portfolio diversification, albeit with significant volatility.

• Structured Products: Custom financial instruments combining elements of traditional securities with derivatives to create specific risk-return profiles, often designed to provide downside protection or enhanced yields.

Each alternative category has unique characteristics, requiring specialized knowledge and careful consideration of various risk dimensions.

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Potential Benefits of Alternative Investments

1. Diversification Alternatives often exhibit lower correlation with traditional assets, potentially improving portfolio efficiency and reducing overall volatility.

2. Inflation Protection Many alternative assets, particularly commodities and real assets, have historically provided hedges against inflation erosion.

3. Access to Inefficient Markets Less efficient markets may offer opportunities for skilled managers to generate alpha (excess returns) through information advantages or specialized expertise.

4. Unique Return Drivers Alternatives respond to different economic factors than stocks and bonds, providing exposure to distinct sources of potential returns.

5. Downside Protection Certain alternative strategies specifically aim to provide capital preservation during market stress, though this varies significantly by approach.

6. Yield Enhancement Some alternatives offer income potential that may exceed traditional fixed-income yields, particularly in low-interest-rate environments.

Key Considerations and Risk Factors

1. Liquidity Constraints Many alternatives feature limited liquidity, with restrictions on withdrawals or investments requiring multi-year commitments.

2. Higher Fees Alternative strategies typically involve higher management and performance fees than passive index investments, creating a higher hurdle for net returns.

3. Complexity Alternative investments often involve more complex structures, strategies, and risks, requiring greater due diligence and understanding.

4. Manager Selection Risk Returns in alternative categories frequently show wider dispersion between top and bottom performers than in traditional asset classes, making manager selection particularly crucial.

5. Valuation Challenges Private or illiquid investments lack transparent market pricing, creating potential for misvaluation or smoothed returns that understate true volatility.

6. Regulatory Differences Alternatives may operate under different regulatory frameworks than traditional investments, potentially offering fewer investor protections.

7. Tax Complexity Many alternative investments generate more complex tax situations, including potentially less favorable tax treatment than long-term stock investments.

While not suitable as core portfolio holdings for most investors, thoughtfully selected alternative investments can complement traditional assets, potentially enhancing returns while managing overall portfolio risk when used appropriately.

Investment Ideas for All Budgets

For Small Investors (1 to 100 Dollars)

Commodity and Digital Asset ETFs

Description: Exchange-traded funds (ETFs) and exchange-traded notes (ETNs) tracking commodities, precious metals, or cryptocurrencies provide cost-effective exposure to alternative asset classes with minimal investment requirements through fractional shares.

Advantages:

• Low minimum investment through fractional share capabilities

• Immediate exposure to alternative assets without storage or security concerns

• Professional management of rolling futures contracts or physical storage

• High liquidity compared to direct ownership of underlying assets

• Simplified tax reporting compared to direct commodity or crypto ownership

Limitations:

• Potential tracking error between fund performance and underlying asset

• Higher expense ratios than traditional index ETFs

• Contango effects in futures-based commodity ETFs can erode returns

• Less direct ownership than physical possession of commodities

• Limited selection of alternatives available through ETF structures

Implementation:

• Research commodity ETFs like GLD (SPDR Gold Shares), SLV (iShares Silver Trust), or DBC (Invesco DB Commodity Index Tracking Fund)

• For cryptocurrency exposure, consider GBTC (Grayscale Bitcoin Trust) or crypto-related ETFs like BITO (ProShares Bitcoin Strategy ETF)

• Start with small allocations (3-5% of portfolio) to gain familiarity

• Focus on physical-backed ETFs for precious metals rather than futures-based products when possible

• Consider automated investment plans to build positions gradually through dollar-cost averaging

• Research tax implications, especially for precious metals ETFs which may be taxed as collectibles

For Medium Investors (101 to 10,000 Dollars)

Alternative Strategy ETFs and Direct Commodity Ownership

Description: Intermediate investors can combine alternative strategy ETFs that replicate hedge fund approaches with modest direct ownership of physical precious metals or digital assets, creating a more diversified alternative allocation.

Advantages:

• Access to hedge fund-like strategies without high minimums or accreditation requirements

• Direct ownership of selected physical assets provides true alternative exposure

• Portfolio diversification across multiple alternative approaches

• Ability to adjust allocations based on market conditions

• Combination of both liquid and moderately illiquid alternatives

Limitations:

• Alternative strategy ETFs may not fully replicate private fund returns

• Storage and security considerations for physical assets

• Higher overall portfolio complexity requiring more research

• Some alternative ETFs have limited track records

• Potentially higher overall fees than traditional investments

Implementation:

• Allocate 60-70% to alternative strategy ETFs like:

  • HFND (IQ Hedge Multi-Strategy Tracker ETF)

  • QAI (IQ Hedge Multi-Strategy Tracker ETF)

  • MNA (IQ Merger Arbitrage ETF)

  • LALT (Legg Mason Diversified Core Alternative Fund)

• Dedicate 20-30% to physical precious metals:

  • Start with 1-ounce gold or silver coins from reputable mints

  • Consider secure storage solutions (home safe or bank safe deposit box)

• Allocate 10-20% to selected cryptocurrencies through established exchanges:

  • Focus on larger market cap cryptocurrencies initially

  • Implement strict security measures (hardware wallets for larger holdings)

• Rebalance annually to maintain target allocations

• Document purchase prices carefully for eventual tax reporting

For Large Investors (10,000 Dollars and Above)

Diversified Alternative Portfolio

Description: With larger capital, investors can create comprehensive alternative portfolios incorporating multiple categories, potentially including access to interval funds, private REITs, registered hedge funds, and more sophisticated commodity exposure.

Advantages:

• More complete diversification across the alternative spectrum

• Access to semi-liquid investment vehicles with potentially higher returns

• Ability to implement strategic allocations based on economic outlook

• Potential to reduce overall portfolio correlation to traditional markets

• Access to alternative income sources during low-yield environments

Limitations:

• Significantly higher complexity requiring substantial research

• Liquidity restrictions on certain investment vehicles

• Higher minimum investments for specialized products

• More complex tax reporting requirements

• Potentially higher transactions costs and management fees

Implementation:

• Core alternatives (40-50%):

  • Interval funds offering private credit, real assets, or hedge strategy exposure

  • Registered alternative funds with quarterly or semi-annual liquidity

  • Consider funds like GIREX (Goldman Sachs Alternative Premia Fund) or QSPRX (AQR Style Premia Alternative Fund)

• Real asset exposure (20-30%):

  • Private REITs focusing on specialized property types

  • Farmland or timberland investment trusts

  • Infrastructure funds investing in essential facilities and utilities

• Commodities and precious metals (15-20%):

  • Diversified commodity futures managed accounts or funds

  • Physical precious metals including gold, silver, and platinum

  • Consider allocated storage programs with professional vaulting

• Digital assets (5-15%):

  • Diversified cryptocurrency allocation across established and emerging assets

  • Potentially cryptocurrency yield platforms for income generation

  • Cold storage solutions for security

• For qualified investors meeting accreditation standards:

  • Consider limited allocations to private equity feeder funds or platforms offering lower minimums

  • Explore specialized collectibles with established provenance through fractional ownership platforms

• Implement systematic quarterly reviews of liquidity constraints and rebalancing needs

• Consider working with specialized advisors for certain alternative categories

Educational Corner: Understanding Correlation in Portfolio Construction

Correlation—the statistical measure of how different assets move in relation to each other—is a fundamental concept in portfolio construction, particularly when incorporating alternative investments. Understanding correlation can help investors build more resilient portfolios that better weather various market environments:

1. Correlation Basics

   • Definition: Correlation is measured on a scale from -1.0 to +1.0

   • Perfect Positive Correlation (+1.0): Two assets move in identical direction and magnitude

   • Perfect Negative Correlation (-1.0): Two assets move in exactly opposite directions

   • Zero Correlation (0.0): Two assets move independently of each other

   • Real-World Range: Most assets show correlations between +0.3 and +0.9 during normal markets

2. The Diversification Benefit

   • Mathematical Advantage: Combining assets with correlations less than +1.0 can improve the portfolio's risk-adjusted return (Sharpe ratio)

   • Volatility Reduction: A portfolio containing assets with lower correlation to each other experiences less overall volatility than the weighted average of its components

   • Efficient Frontier: The optimal mix of assets with different correlations creates a curve of portfolios offering the highest expected return for a given level of risk

   • Diminishing Returns: The marginal benefit of adding another asset decreases as the portfolio grows more diversified

3. Alternatives and Correlation

   • Historical Patterns: Many alternative investments have historically demonstrated lower correlation to traditional stocks and bonds:

     • Gold often shows negative correlation to stocks during market stress

     • Managed futures strategies have provided crisis alpha during major market downturns

     • Market-neutral hedge funds aim for zero correlation to broader markets

     • Real assets like timberland have shown low correlation to financial assets

   • Correlation Instability: Correlations aren't fixed and tend to increase during market crises when diversification is most needed

   • Secular Shifts: Long-term changes in economic regimes can alter historical correlation patterns

4. Practical Application

   • Correlation Matrix: Create or review correlation matrices showing how different assets have moved in relation to each other over various timeframes

   • Stress Testing: Examine how correlations changed during previous market disruptions rather than relying solely on long-term averages

   • Forward-Looking Assessment: Consider how economic changes might alter historical patterns

   • Correlation vs. Diversification: Remember that low correlation is just one aspect of diversification—volatility differences and return patterns also matter

   • Tactical Considerations: Correlation patterns may suggest opportune times to adjust alternative allocations

Understanding correlation dynamics allows investors to move beyond simple asset allocation to more sophisticated portfolio construction, potentially achieving better risk-adjusted returns by strategically combining traditional investments with carefully selected alternatives that offer truly different return patterns.

Did You Know?

In January 2022, global auction house Sotheby's announced that a single collection of 104 CryptoPunks NFTs (non-fungible tokens) was expected to sell for $20-30 million, highlighting the extraordinary evolution of digital collectibles as an alternative asset class. Just five years earlier, these same digital images could have been purchased for mere hundreds of dollars each. While this particular auction was ultimately withdrawn at the last minute when the collector decided to hold rather than sell, it demonstrated how quickly new alternative asset categories can emerge and reach institutional scale. This rapid development mirrors historical patterns seen in other alternative investments that evolved from niche interests to mainstream asset classes, including venture capital in the 1980s, hedge funds in the 1990s, and private equity in the 2000s. Whether NFTs and digital collectibles establish long-term investment legitimacy remains uncertain, but their emergence illustrates how technological innovation continually creates new potential avenues for diversification beyond traditional markets.

That concludes this article of How to Invest. Alternative investments offer a diverse range of options beyond traditional stocks and bonds, potentially providing portfolio diversification, inflation protection, and access to unique return drivers. While alternatives typically involve greater complexity, higher fees, and often reduced liquidity compared to traditional investments, thoughtfully selected alternatives can enhance portfolio resilience across different market environments. Whether starting with commodity ETFs, building exposure through alternative strategy funds, or creating a comprehensive alternative portfolio, the key to success lies in understanding each alternative's unique characteristics and how they interact with your existing investments.