Alternative Investments - Definition & List

Andrew Goldman

Andrew Goldman has been writing for over 20 years and investing for the past 10 years. He currently writes about personal finance and investing for Wealthsimple. Andrew's past work has been published in The New York Times Magazine, Bloomberg Businessweek, New York Magazine and Wired. Television appearances include NBC's Today show as well as Fox News. Andrew holds a Bachelor of Arts (English) from the University of Texas. He and his wife Robin live in Westport, Connecticut with their two boys and a Bedlington terrier. In his spare time, he hosts “The Originals" podcast.

There’s more investing options than just stocks and bonds. They’re called alternative investments. Here’s a handy guide and how to invest in them like a pro.

What are alternative investments

Alternative investments might sound like a kind of crowdfunded scheme to sponsor a Tame Impala world tour, but they’re actually a considerably more legit investing category than that. In simple terms, alternative investments are any investment that don’t fit into the category of stocks, bonds, or cash and aren’t priced or valued in a way that is directly correlated to any of these things. Alternative investments, however, may invest in one of these traditional categories but in a non-traditional manner such as shorting or arbitrage, a fancy term for taking advantage of a price difference in two markets for the same security. Obviously, there’s scads of stuff you can invest in that’s not a stock, bond, or cash. Real estate, commodities and hedge funds and private equity are considered alternative investments. Art, wine and antiques would be considered others. Beanie babies, PokémonTrading cards, and a lock of Mick Jagger’s hair would all be considered alternative investments too. As with everything else, not all investments are created equal and the vast universe of alternative investments provides almost limitless opportunities for losing a fortune, so you should proceed with an excess of caution when investing. We’ll try to to get you in the right frame of mind.

Wealthsimple Invest is an automated way to grow your money like the worlds most sophisticated investors. Get started and we'll build you a personalized investment portfolio in a matter of minutes.

Benefits of alternative investments

There are a number of reasons why alternative investments might be appealing, but the absolutely best one is diversification. One of the most important tenets of smart investing is that not only should you not put all your eggs in one basket, you should deposit those eggs in pretty much as many baskets as you can get your hands on.

Why? Diversification is about reducing risk and enhancing return. During those inevitable periods when some of your investments are performing poorly you’ll want other investments to make up some of those losses. Bond investments generally do well when stocks are down. But because alternative investments’ performance generally doesn’t correlate with other investment categories, in them you’ll find an investment that has a chance of performing well in conditions that have absolutely nothing to do with the performance of stocks and bonds.

Drawbacks of alternative investments

Though these certainly don’t pertain to all alternative investments or strategies, the main drawbacks often cited are:

  • Illiquidity: They can be tougher to sell than many other investment types.

  • Volatility: Their prices rise and (more importantly) fall more dramatically than other investments.

  • Barriers to entry: Some alternative investments just cost too much for most investors. Want to start investing in Van Goghs? Great! Got $81 million lying around?

How do alternative investments work

The thing about alternative investments is as a group, they’re kind of like the characters in heist movies—an unruly bunch of characters thrown together with nothing in common but the desire to make a lot of dough. So it’s hard to generalize about how they “work.” As with any investment, you do your homework, invest your money and hope for the best.

There are scads of of different types, though there is some agreement about which alternative investments are the most prevalent and legit. Below, find an introduction to the biggies.

List of alternative investments

We don’t play favorites here, so we’re arranging these alphabetically.

1. Commodities

Commodities are goods and raw materials that are traded on markets. From a quality perspective, they are standardized and interchangeable and are often used as materials or ingredients in commercial products. For example, steel, gold, natural gas and beef are all commodities.

You can invest in commodities directly by actually buying them. Buy a gold coin or a cow and, voila, you’re a commodity investor. You’re free to sell your gold coins or cow to whomever you like, but commodities can only be traded on commodities markets, like the Chicago Mercantile Exchange. Many investors prefer to get into commodities by using a brokerage to buy futures, which are obligations to buy or sell commodities at a certain price. Futures fluctuate in value depending on how in demand the commodity is at a certain point in time and whether you’ve longed or shorted the commodity. Don’t worry about storage for commodities if you’re buying futures; generally, when someone is investing in commodities futures, they’ll never physically take possession of the commodity. This guide on gold and silver futures will provide a deeper explanation of how futures work.

The cheapest, easiest way to invest in commodities is to find an ETF that invests in one, some or even the entire commodities market, or ETFs investing in companies that are dependent on specific commodities.

2. Real estate

You know what real estate is! It’s a house, an apartment building, a mall, a shopping center or an undeveloped acre of land. It’s property or land and often it’s both.

Anyone who’s own a house or apartment is a real estate investor, and for many, this is the sole investment in their portfolio, since home ownership has been for generations a kind of forced saving plan for undisciplined investors and those struggling to make ends meet. Without that monthly mortgage payment, many might not have saved anything at all. But you may hope to invest in real estate you don’t actually reside inside. Watch enough cable TV, and you’ll assume that anyone with a tape measure and a barrel of hair gel can make millions flipping real estate. In reality, it’s a business with huge risks that have been known to ruin unwise speculators). Those who would like to diversify through real estate investment without having to fix leaky toilets or answer calls from whiny tenants might consider investing in real estate investment trusts, or REITs, companies that sell shares in their various real estate investments. REIT investors can spread their risk among dozens — or even hundreds — of REITs through REIT ETFs, of which there are literally hundreds to choose from. REITs also offer some major tax benefits that neither home ownership, nor investments in stocks or bonds, offer.

3. Direct investment in start-ups and private companies

You’ve probably heard stories about a guy who gave Jeff Bezos 300 bucks in 1994 and now owns a continent. Or a grandma who invested all her savings into Theranos and now lives in her Buick. Startups are “either home runs or they’re strikeouts,” New York based securities lawyer Gregory Sichenzia told U.S. News recently, so anyone investing in them should be aware that they run the risk of losing every cent they invest.

Thanks to a 2012 law that loosened the restrictions on crowdfunding for startups, investing in private companies is easier than it’s ever been and available to basically any level investor. Risks and rewards will generally be commensurate with the investment stage you invest in: those who invest in the seed round of a company will more likely lose their entire investment (with a small chance to score huge) than someone investing in a company in its late stage round. Vetting startups is no small task, so companies like SeedInvest have entered the fray promising that they will help small investors find startup opportunities with companies that have had their tires thoroughly kicked. (They say they accept less than 1% of applicants.)

The downside of any kind of investment in a startup is in most cases, your money will be tied up until the company is acquired or goes public. One way of gaining exposure to the potential upsides of startups while not going all in on one specific company is to invest in one or more publicly traded venture capital firms.

4. Private Equity

In general, private equity’s goal is buying companies that are not publicly held, or taking publicly held companies private, making whatever changes need to be made to the company to make it more valuable, and selling it at a profit.

Private equity investments generally come through private equity firms or funds. Investing directly in a company through a private equity firm will take a lot of dough: one recent estimate put the number at somewhere between $200,000 to $1 million to invest through a firm.

There are three main methods for less flush investors to get in. A fund of funds (FOF) will wrap together multiple private equity funds for investment. From a diversification perspective, this makes an investment less risky than direct investment in just one company. However, as outlined in this article, fund of fund fees tend to be substantial, since FOF managers typically charge investors an annual fee of around 1 percent, which is an addition to the standard “2-and-20” structure charged by the private equity firms in which they invest (an annual 2% cut of all assets in the fund and a 20% of all profits.) A more thrifty option would be to purchase an ETF specifically tracking publicly traded companies investing in private equity, or even the shares of a publicly traded private equity company, though the latter method would naturally provide less diversification than an ETF.

5. Hedge funds

When hedge funds first emerged they were so-named because they were investment vehicles that by longing or shorting stocks would be market neutral, or able to succeed irrespective of overall stock market conditions, thereby hedging market risk. But they’ve evolved considerably beyond longing and shorting stocks, and hedge funds often operate according to whatever esoteric financial strategy dreamed up by the hedge fund manager. In the boom years following 2008’s global financial crisis, hedge funds took a reputational hit, because only once in a decade did their performance surpass that of the S&P 500 so investors in cheap market-tracking index funds and ETFs earned better returns than the big shots. The typical hedge fund fee structure, in which the fund manager takes an annual 2% of all fund assets plus 20% of profits, didn’t seem be producing the kinds of results to justify such a princely cut, though they may make a comeback when the markets inevitably go south.

Because hedge funds are less regulated than mutual funds and can be more volatile, the SEC requires almost all hedge fund investors to be accredited, a fancy term for being rich enough to lose a lot of money. The process requires prospective investors to assert that they have $1 million net worth (apart from their house value) or make $200,000 a year, or $300,000 for couples. (The accreditation process falls to the hedge fund manager so it may not be nearly as rigorous as the government intended.) There’s typically a high barrier to entry of between $500,000 and $1 million for an initial investment, and the better performing hedge funds may require much, much more. A new breed of hedge fund “lite” has arrived in the last few years, but these still may require $100,000 or more of a minimum investment.

Last Updated June 23, 2020

Wealthsimple is investing on autopilot.