An alternative investment is one that isn’t a stock or bond. Traditionally, ownership in companies was the most valuable asset with ownership of their debt a close second.
However, as the number of high-value assets that can attract significant investment continues to rise, interest in alternatives rises too. Whether they’re artworks, real estate or digital assets, these are alternative investments.
How do you know you’re looking at an alternative investment?
There’s no cut-and-dried definition. Instead, you can apply these three tests:
Is it traded on an exchange?
Alternative investments are typically not traded on exchanges the way stocks and bonds are. Anything that isn’t or can’t be traded this way — real estate, paintings — is probably an alternative investment.
Does it track the market?
Alternative investments don’t usually track the stocks and bonds market. They might boom while Wall Street stumbles or crash while the market roars. They might be largely unaffected by market changes.
For this reason alternative investments are often used as diversifiers, and one of the main reasons that investors express interest in alternative investments is to spread risk and reduce their vulnerability to market volatility.
Can it be held in a pension plan?
Retirement accounts are often limited in the types of assets they can hold. It’s not uncommon to find the list restricted to stocks, bonds, mutual funds and cash. But this restriction is not imposed by legislation or regulation. It’s a preference of the brokerage firms and pension providers who wield power in the space. (In the United States, the legality of holding alternative investments in pension funds was established by the 1974 Employee Retirement Security Act.) The proportion of pensions investment in alternative investment has been rising rapidly in recent years, more than doubling between 2005 to 2015 from 9% to 24%.
Why are alternative investments increasingly popular?
Alternative investments are attractive to investors seeking higher returns and safe haven investments.
Even before the Covid-19 pandemic’s effects on the world’s economies and markets, traditional investments suffered low yields. In addition, traditional investments are a long-term prospect. The Standard & Poor 500 returned around 13% over ten years during the period from 1945 to 1995. But some investors don’t want to wait ten years for a return. And in the years between 1995, yields have been lower and much more unpredictable.
While alternative investments represent a better return for some investors, they also represent a safer place to store capital during turbulent times. Many alternative investments hold value well and are not susceptible to market sentiment. Some investments are strongly susceptible to changes in interest rates, such as utilities and real estate stocks; alternative investments are often less affected by such changes, making them a desirable safe haven.
Alternative investments offer advantages including:
- More predictable income: Alternative investments may not outperform the top-performing S&P stocks in any given year, but they often offer more reliable and predictable returns than the S&P’s bottom performers, and — crucially - they’re less affected by market and interest rate fluctuations, so they deliver much more predictably.
- Reduced transaction costs: In many cases, alternative investments aren’t susceptible of being transacted: if they can’t be divided or transported, like artworks or some buildings, they can be bought or sold but not traded in the same way as traditional stocks and bonds. In addition, alternative investments don’t have an established system of considering holding periods the way traditional stocks do. Some alternative assets are intergenerational while others may be held for just months. In the case of longer-term holdings there are no transactions and thus no fees. This is particularly true of operating assets such as real estate, which often form portions of legacies or pension investment portfolios.
- Tax advantages: Alternative investments used for long-term investments deliver noticeable tax advantages over traditional investments. That’s particularly true if they’re held in locations like Hong Kong with laws that favor the asset holder. Personal retirement funds like ORSs can accumulate tax-free retirement income in locations like Hong Kong; even in other jurisdictions a strategy based on alternative investments is capable of generating better returns with lower tax liability.