Funds of hedge funds
If you do not
qualify to invest directly in a hedge fund, you
may be able to find a fund
that invests in multiple hedge
funds and requires a lower minimum investment, though that minimum usually
is still higher than most
By investing in multiple investing styles, managers,
and strategies, a fund of
funds may provide greater
diversification than a single
Be aware that a fund of funds
may or may not be registered
with the SEC; be sure to
check. Even if it is registered,
protections apply only to the
fund of funds, not necessarily to the
underlying funds in which it
invests. Also, you will pay fees charged by both the fund of funds and each underlying fund.
Before investing in a mutual fund or ETF, including one that invests in any kind of alternative asset class, carefully consider its investment objectives, risks, fees, and expenses, which can be found in the prospectus available from the fund. Read it carefully before investing. REITs are also sold by prospectus.
Beyond Traditional Asset Classes: Exploring Alternatives
Stocks, bonds, and cash are fundamental components of an investment
portfolio. However, many other investments can be used to try to spice
up returns or reduce overall portfolio risk. So-called alternative assets
have become popular in recent years as a way to provide greater diversification.
What is an alternative asset?
The term "alternative asset" is highly flexible; it can mean almost
anything whose investment performance is not correlated with that of
stocks and bonds. It may include physical assets, such as precious metals,
real estate, or commodities. In some cases, geographic regions, such
as emerging global markets, are considered alternative assets. Complex
or novel investing methods also qualify. For example, hedge funds use
techniques that are off-limits for most mutual funds, while private equity
investments rely on skill in selecting and managing specific businesses.
Finally, collectibles are included because the value of your investment
depends on the unique properties of a specific item as well as general
interest in that type of collectible.
Each alternative asset type involves its own unique risks and may not
be suitable for all investors. Because of the complexities of these various
markets, you would do well to seek expert guidance if you want to include
alternative assets in a portfolio.
Hedge funds are private investment vehicles that manage money for institutions
and wealthy individuals. They generally are organized as limited partnerships,
with the fund managers as general partners and the investors as limited
partners. The general partner may receive a percentage of the assets,
fees based on performance, or both.
Hedge funds originally derived their name from their ability to hedge
against a market downturn by selling short. Though they may invest in
stocks and bonds, hedge funds are considered an alternative asset class
because of their unique, proprietary investing strategies, which may
include pairs trading, long-short strategies, and use of leverage and
derivatives. Participation in hedge funds is typically limited to "accredited
investors," who must meet SEC-mandated high levels of net worth
and ongoing income (individual funds also usually require very high minimum
Private equity/venture capital
Like stock shares, private equity and venture capital represent an
ownership interest in one or more companies, but firms that make private equity investments may or may not be listed or traded on a public market
or exchange. Private equity firms often are involved directly with
management of the businesses in which they invest.
Private equity often requires a long-term focus. Investments may take
years to produce any meaningful cash flow (if indeed they ever do); many
funds have 10-year time horizons and you may not have access to your funds when you want them. Like hedge funds, private equity also
typically requires a large investment and is available only to investors
who meet SEC net worth and income requirements.
You may make either direct or indirect investments in buildings — either
commercial or residential — and/or land. Direct investment involves the
purchase, improvement, and/or rental of property. Indirect investments
are made through an entity that invests in property, such as a real estate
investment trust (REIT), which may be either publicly traded or not. Real estate not only has a relatively low correlation
with the behavior of the stock market, but also is often viewed as a
hedge against inflation. However, bear in mind that physical real estate can be highly illiquid, may involve more work on your part to manage, and may be subject to weather hazards, rezoning or other factors that can reduce the value of your property. The value of a traded REIT will depend on fluctuations in the value of its real estate holdings as well as investor sentiment and market volatility. The value of a nontraded REIT is directly based on the value of its underlying real estate holdings. All REITs are subject to the risks associated with the real estate market in general. Also, some types of REITs are considered more illiquid than others, which could mean problems if you need to sell quickly.
Investors have traditionally purchased precious metals because they
believe that gold, silver, and platinum provide security in times of
economic and social upheaval. Gold, for instance, has historically been
seen as an alternative to paper currency and therefore may help hedge
against inflation and currency fluctuations. As a result, gold prices
often rise when investors are worried that the dollar is losing value,
though prices can fall just as quickly.
There are many ways to invest in precious metals. In addition to buying
bullion or coins, you can invest in futures, shares of mining companies,
sector funds, and exchange-traded funds (ETFs).
Natural resources/equipment leasing
Direct investments in natural resources, such as timber, oil, or natural
gas, can be done through limited partnerships that provide income from
the resources produced. In some cases, such as timber, the resource replenishes
itself; in other cases, such as oil or natural gas, it may be depleted
over time. Timberland also may be converted for use as a real estate
development. Some limited partnerships pool your money with that of other investors to invest in equipment leasing businesses, giving you partial ownership of the equipment those businesses lease out, such as construction equipment.
Commodities and financial futures
Commodities are physical substances that are fundamental to creating
other products and are basically indistinguishable
from one another. Examples include oil and natural gas; agricultural
products; livestock such as hogs; and metals such as copper and zinc.
Commodities are typically traded through futures contracts, which promise
delivery on a certain date at a specified price. Futures contracts also
are available for financial instruments, such as a security, a stock
index, or a currency. Though the futures market was created to facilitate
trading among companies that produce, own, or use commodities in their
businesses, futures contracts also are bought and sold as investments
in themselves, and some mutual funds and ETFs are based on futures indexes.
Futures allow an investor to leverage a relatively small amount of
capital. However, they are highly speculative, and that leverage also
magnifies the potential for loss in a relatively short period of time.
Art, antiques, gems, and collectibles
Some investors are drawn to these because they may retain value or even appreciate as inflation
rises. However, those values can be unpredictable because they are affected
by supply and demand, economic conditions, and the quality of an individual
piece or collection.
Why invest in alternative asset classes?
Part of sound portfolio management is diversifying investments so that
if one type of investment is performing poorly, another may be doing
well. As previously indicated, returns on some alternative investments
are based on factors unique to a specific investment. Also, the asset
class as a whole may behave differently from stocks or bonds.
An alternative asset's lack of correlation with other types of investments
gives it potential to complement more traditional asset classes
and provide an additional layer of diversification for money that is
not part of your core portfolio, though diversification cannot guarantee
a profit or ensure against a loss.
Tradeoffs you need to understand
Alternative assets can be less liquid than stock or bonds. Depending
on the investment, there may be restrictions on when you can sell, and
you may or may not be able to find a buyer. Performance, values, and
risks may be difficult to research and assess accurately. Also, you may
not be eligible for direct investment in hedge funds or private equity.
The unique properties of alternative asset classes also mean that they
can involve a high degree of risk. Because some are subject to less regulation
than other investments, there may be fewer constraints to prevent potential
manipulation or to limit risk from highly concentrated positions in a
single investment. Finally, hard assets, such as gold bullion, may involve
special concerns, such as storage and insurance, while natural resources
and commodities can suffer from unusual weather or natural disasters.