Alternative investments are very popular among institutional and sophisticated investors due to their complex nature and limited regulation. Although relatively illiquid, alternative investment strategies leverage investment risk with the potential to achieve higher returns through lower volatility and increased portfolio diversification. In this context, large pension and private capital funds allocate 10 percent of their portfolios to alternative investments, including real estate, commodities, hedge funds, and structured products.
- Real estate
The 2006 housing bubble has made investors nervous as to whether investing in real estate is a prominent investment choice. Real estate includes investments in land, residential and industrial buildings. The ownership of intangible assets allows you to trust your money with companies that create value by hedging risk. The volatility is relatively low and, with the exception of property taxes, real estate can provide you with a fixed return. You can invest in real estate via rental properties, real estate investment groups or real estate investment trusts (REIT).
Commodities include a variety of assets such as crops (wheat, corn, and soybeans), precious metals (gold, nickel, copper, and aluminum), coffee, oil and live cattle. The high volatility of the market allows for higher returns, but, on the other hand, the risk is also high. For instance, a drought can cause the crop prices to skyrocket due to scarcity in supply. Similarly, a huge supply can cause the price to drop dramatically.
- Hedge Funds
Hedge funds cater to sophisticated investors who aim at diversification through investing in a variety of financial vehicles, including equities and derivatives. By being actively managed and often aggressively positioned, hedge funds are more flexible and less regulated than mutual funds, thereby allowing a higher return potential through differentiated investment strategies. The only setback of hedge funds is volatility and the minimum investment of $1 million.
- Structured products
The most common structured product is the mix of a debt security with an equity security. In a structured product, the cash flows of the bond are structured to meet the cash flows of the equity. In that way, the product mitigates risk. The payoffs of structured products depend on the underlying security that may be a future, an option, a swap, and so on This means that structured products are more related to options pricing rather than to traditional equity and therefore they always include an embedded part. On the downside, the structured products are rather illiquid due to high customization and their returns are not realized before maturity. Therefore, they are not really flexible.
- Private Equity
Private equity offers a variety of funding opportunities that incur a high risk. On the other hand, private equity requires detailed industry knowledge and the skills to leverage risk as well as the implementation of long-term strategies and the use of asymmetric information to take advantage of investment opportunities. Due to these factors, the private equity offers great diversification alternatives and a higher return potential.
The Bottom Line
Investors who seek for diversification prefer alternative investments over equity and fixed income securities to achieve higher returns at a lower risk. What makes alternative investing quite attractive is the fact that the portfolio’s performance is based on the manager’s skills rather than on the company’s ability to create value. This allows investors to make well-informed investment choices based on absolute performance rather than on historical value and achieve their return goals.
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