Investing 101: Alternative investments
This is part 8 of the Investing 101 series. If you are new to investing, I strongly recommend reading the series from the beginning. Up until now, the series has focused on stocks and bonds. In this article, I will discuss some assets known as “alternative investments”. What are the best alternative investments, and are any alternative investments worth the risk? Read on to find out!
What are alternative investments?
In the world of investing, cash, stocks, and bonds are “conventional” assets, and any asset class other than cash, stocks, or bonds is an alternative investment. As you can imagine, the number of alternative investments out there far surpass conventional asset classes. Some common alternative investments are, in no particular order, real estate, commodities, private markets (private equity and debt), forex, hedge funds, cryptocurrency, and collectibles.
In my opinion, alternative investments are not necessary for a balanced and well-diversified portfolio. Conventional asset classes have a long, proven track record of historical performance, have financial transparency (by law), are extremely liquid (public equity and debt markets are some of the largest markets in the world), are widely available to almost everybody, and have plenty of regulatory protection against fraud and malfeasance. Alternative investments, however, may lack some or all of these benefits. Regardless, alternative investments are attractive to some investors because they offer even further diversification of traditional portfolios, and they tend to differ from conventional assets significantly in risk/reward profile.
Alternative investment characteristics
Alternative investments represent a very heterogenous group of asset classes with very different characteristics. Broadly speaking, however, many alternative investments have one or more of the following characteristics:
New or emerging technologies, markets, or assets with little historical data (i.e. cryptocurrency, NFTs)
High volatility and risk, and along with that, high potential returns (i.e. forex, cryptocurrency)
Low correlation with stock market or bond returns (i.e. real estate, commodities, cryptocurrency)
Financial statements are not disclosed or not fully transparent (i.e. private markets, hedge funds)
Lack of regulatory oversight (i.e. cryptocurrency, private markets, hedge funds)
Low trading volume or liquidity (i.e. real estate, some commodities and cryptocurrencies, collectibles)
Valuations are arbitrary or speculative (i.e. cryptocurrency, collectibles)
Not available to the public, or require accredited investor status to invest (i.e. private markets, hedge funds)
With regard to the last point, many hedge funds, private debt markets, and private equity funds are beyond the reach of the general public, requiring accredited investor status as well as millions of dollars of minimum investment or buy-in. In the United States, the Securities and Exchange Commission (SEC) defines an accredited investor as someone who:
earned income that exceeded $200,000 (or $300,000 together with a spouse or spousal equivalent) in each of the prior two years, and reasonably expects the same for the current year, OR
has a net worth over $1 million, either alone or together with a spouse or spousal equivalent (excluding the value of the person’s primary residence).
The full criteria for qualifying as an accredited investor can be found on the SEC website.
Before we go any further, I want to make it very clear that while being an accredited investor is a special status which can open up new investment opportunities, these opportunities are not necessarily better than conventional investments. Investments requiring accredited investor status are usually much riskier and lack regulatory oversight or safeguards. Accredited investors are allowed to participate in these investments not because the SEC believes that they should have special privileges, but because the SEC believes that they are wealthy enough to not need regulatory protection and can afford to suffer financial loss.
Real estate
Real estate is considered an alternative investment, but among all of the alternative asset classes, real estate is probably the most popular and well-accepted. Both public and private real estate investment is extremely viable, either as a replacement of conventional investments entirely, or as an adjunct to a conventional stock and bond portfolio. And while real estate isn’t without its downsides, it has little in common with other alternative asset classes, which tend to be far more speculative in nature. I won’t go into too much detail about real estate here, but I do have a separate article that examines the merits of real estate and compares investing in real estate versus the stock market.
Commodities
Commodities are physical goods or materials which are used in commerce or industry. Examples of commodities include grains, livestock, cotton, oil, natural gas, and metals. Trading in commodities is probably the oldest type of trading in the world, and the global commodities market today is a massive one. The main players in commodities trading are institutions who are actually interested in acquiring the physical asset for use in industry, and speculators who have no interest (and no feasible way to take delivery) of the underlying asset, but instead trade derivative contracts such as options and futures, essentially making bets about a commodity’s price change.
Most commodities are finite in supply and have a defined cost of production (to mine, drill, grow, etc.), and are subsequently consumed in another economic or industrial process. Ultimately, all commodities derive their value from this supply and demand. Most commodities are unsuitable as “buy and hold” investments, however, for 3 reasons:
They are not income-producing assets on their own. Unless you use it, it just sits there, and it will never pay dividends.
Many commodities are perishable and cannot be stored forever.
Many commodities are infeasible for the average person to store or transport.
Therefore, the commodities market is more suitable for short-term trading rather than long-term investing. At the same time, however, average investors really should not attempt commodities trading, as commodity markets are highly complex, commodity prices can fluctuate wildly, and “black-swan” events can happen on a regular basis. For example, oil prices sometimes go negative, an otherwise inexplicable set of events that does not happen with other asset classes. And because much of commodities trading is done through derivative contracts which are highly leveraged, even experienced traders can be caught with their pants down. In 2018, a fund known as Optionsellers.com imploded spectacularly after selling naked calls on Natural Gas, and the story quickly went viral. The price of Natural Gas spiked for 1 week in November 2018 before returning to its long-term baseline, but this one week was sufficient to wipe out more than 100% of the fund at an estimated $150 million dollars - the fund not only lost all of its assets, but clients also owed additional money at the end. Imagine getting an email like this one:
Multiple factors were at play here, with the main one being selling naked call options, which have unlimited potential loss. The volatile nature of commodities, however, certainly contributed.
With all that being said, there is one commodity that many individual investors do buy and hold: Gold. Gold has some minor industrial uses, but the overwhelming demand for gold comes from jewelry and investment demand. Physical gold minted specifically for investment is readily available for purchase in the form of coins and bars. The merits of gold as an investment are beyond the scope of this article, but some people do allocate a small percentage of their portfolio to physical gold, as either a “store of value”, a “safe haven” asset, or a hedge against hyperinflation.
Cryptocurrency
For a long time, I entirely ignored cryptocurrency as an asset class, because it seemed contrary to everything I knew about sensible investing. Lately, however, my opinion on cryptocurrencies has changed. My recent experiences of mining Ethereum on my home computer and mining Cardano on its proof of stake network compelled me to do further research into the nature of cryptocurrencies, blockchain technology, and the concept of decentralized finance, or “DeFi”. I used to think that cryptocurrencies were completely useless, but now I believe that many blockchain networks have very legitimate utility.
2021 was also a banner year for many cryptocurrencies, with prices skyrocketing to all-time highs and widespread institutional adoption. More and more companies are beginning to accept cryptocurrency for payment, including the likes of PayPal, Microsoft, Home Depot, and Starbucks. And recently, several countries, including El Salvador and Panama announced their intentions to accept bitcoin as legal tender. This level of institutional adoption continues to put cryptocurrencies on the path towards becoming true alternatives to current government fiat currencies.
Unfortunately, the overall cryptocurrency market is still rife with peril and uncertainty:
First, there are thousands of different crypto coins in circulation (as of this writing, coinmarketcap.com tracks over 10,000 different crypto coins!), and the overwhelming majority of them will not reach widespread adoption and are, or will become, dead coins. Investors in these coins are likely to lose most, if not all of their investment. Worse, many cryptocurrencies have been introduced from the outset purely as ponzi or pump-and-dump schemes.
Second, many cryptocurrency networks, especially those using proof-of-work algorithms, are increasingly facing criticism due to their environmental impact. I covered this in more detail in my Cardano mining article.
Third, because of their security, anonymity, and decentralized characteristics, cryptocurrencies have also become havens for criminal activity such as extortion and money-laundering. The internet is now also full of cryptocurrency scams. Cryptocurrency investing requires a significant degree of technical savvy and due diligence to ensure wallet security and prevent fraud, theft, and loss, as the investor takes on the responsibility of being their own bank, with no government protection such as the FDIC or SIPC.
Finally, cryptocurrencies are incredibly volatile, and some of this volatility is undoubtedly due to the fact that it is difficult to accurately value most crypto coins. Unlike stocks, it is difficult to apply any kind of “fundamental analysis” on crypto. Therefore, crypto valuations tend to be quite arbitrary and speculative. A good example is Dogecoin, which has no actual utility, but nonetheless became the 5th largest cryptocurrency by market cap at one point based purely on memes and speculation.
The bottom line is that I think cryptocurrency is here to stay, although it may still take years or decades before mass acceptance. Over the past 40 years, the same happened with the internet: it morphed from being an interesting concept to becoming an essential public utility. However, its impossible to say which specific cryptocurrencies will stand the test of time. In fact, the dominant blockchain network in 30 years may not even exist today, just as how the likes of Facebook and Netflix were not around during the dot-com craze. What a fascinating time we live in.
Private markets
The stock market is a public equity market and the bond market is a public debt market, but these are not the only equity and debt markets that exist. In addition to these public markets, there are
private equity markets and private debt markets as well. Both are exactly what they sound like. Private equity invests in private companies which are not available on the public stock market, and private debt invests in private loan opportunities instead of bonds. Generally speaking, private equity and debt markets are not very transparent and the investor assumes significant risk in exchange for high potential returns. Also, due to their nature as private markets, these opportunities are typically unavailable to the average investor.
The main way that high net worth individuals can enter these private markets is to participate in “concierge” financial services, such as private banking and private wealth management. Often, this works on a “don’t call us, we’ll call you” type of arrangement: once your net worth becomes high enough, banks and brokerages become increasingly interested in taking you on as a private client. From here, you can enroll in private investment accounts to gain access to more proprietary investment products, such as private markets and some hedge funds. Most banks have specific departments dedicated to serving only their high net worth clients.
The requirements for private banking and private wealth management are not always made public. Also, there is some overlap between private banking and private wealth management services, as the line between a bank and a brokerage gets increasingly blurry at the top. The following table shows a chart of some well-known financial institutions and their minimum requirements.
| Institution | Minimum Requirements (if known) |
| Chase Private Client | Daily minimum account balance > $150,000 |
| Bank of America Private Bank | Approximately $10 million in investable assets |
| Citigroup Citigold | Monthly average account balance > $200,000 |
| Wells Fargo "The Private Bank" | Minimum $1 million in investable assets |
| Goldman Sachs Private Wealth Management | "must generally have a minimum of $10 million in investable assets" |
One of my friends, who is a very high net worth individual, tells me that some institutions, such as JP Morgan Chase, have several tiers of private banking services, with their second tier starting at $10 million. Again, this sort of information is often not publicized, although I have no reason to doubt his claims. This number ($10 million) also happens to be the widely-reported minimum balance required to qualify for the Chase Palladium credit card.
Outside of going through private banking and wealth management, there are a few “publicly available” services which purport to offer private equity or debt investments. Most of these still require accredited investor status, however, and have high minimum investment requirements. Some examples of private market investment services include:
Yieldstreet. Invests in a mixed portfolio of alternative asset classes, including private equity, private debt, private real estate, and even things like oil tankers and fine art. Their fees tend to exceed 1%, and most of their investment offerings, except their main fund, require accredited investor status. Yieldstreet also offers multiple private financing deals with tantalizingly high returns, but it is difficult to know how many of their offerings end up defaulting since they do not disclose this. A recent Yieldstreet deal to finance a ship scrapping operation in Dubai went south, and investors may have lost as much as $85 million; investors on internet forums have also claimed that many of their prior offerings are have defaulted with partial or total loss of principal. That entire forum thread is a fascinating read, and is in stark contrast to Yieldstreet’s slick website and advertising.
Fundrise. A crowd-funded platform which invests in private real estate. Fundrise is essentially a private real estate investment trust (REIT) instead of a public one. Fundrise’s fund has seen impressive returns since inception, currently averaging about 10% annualized returns since 2014, and has slightly outperformed Vanguard’s real estate index fund over the same time period (ending in 2020), but still lagged the overall stock market. I should note, however, that Vanguard’s real estate index fund is up over 30% YTD in 2021, so the public REIT market is rebounding quickly. Fundrise is still relatively new, but in the long-term, I expect that Fundrise’s performance will not differ meaningfully from public real estate investments. Fundrise charges a reasonable 0.15% fee.
Alumni venture group. Invests in venture capital (startups and pre-IPO companies) which are otherwise unavailable to most investors. AVG funds require accredited investor status and charge hefty fees (so-called “2 & 20”; 2% annual fee and 20% of profits, similar to most hedge funds). AVG also has various “venture clubs” formed by alumni of elite universities who invest together. Most AVG funds have very high minimum investment requirements. It is difficult to gauge AVG’s historical returns as their funds have very complex structures, but their recent performance summary paints a decidedly mixed picture. AVG was founded in 2013, and their initial funds from 2014 have, by 2020, achieved an average of 1.88x “cash-on-cash” return after fees, although each of their funds run for 10 years, so final performance is unknown. An investment in the S&P 500 in 2014 with dividends reinvested, however, would have yielded 2.42x the initial value by the end of 2020, so AVG’s longest running fund has severely underperformed the public stock market.
Equitybee, EquityZen, Microventures, and similar platforms: These services provide a secondary marketplace for shares of startups and pre-IPO companies. Many startup companies offer stock options to its employees, although there is no open market for these stock options until or unless the company eventually goes public. Services such as EquityBee provide a secondary marketplace for these stock options to employees who want to cash out before then. The employee receives capital for their stock options, and investors who purchase these stock options get the ability to invest in pre-IPO companies in return. These platforms require accredited investor status.
This is far from an exhaustive list of services that provide private market investments. Overall, I encourage extreme caution when investing with any service that offers exposure to private markets due to lack of regulatory oversight and lack of financial transparency.
Hedge funds
Hedge funds are a type of investment fund which utilizes more complex trading strategies than traditional mutual funds, including short selling (traditional mutual funds only hold assets in long positions), derivatives (such as options trading), and use of leverage. These funds are typically marketed towards institutional investors and high net worth individuals. The SEC has strict regulations about who can invest in hedge funds, but with very few exceptions, hedge funds are only available to accredited investors.
The name “hedge fund” comes from their original premise, which is the ability to utilize strategies such as leverage and short selling to “hedge” against market downturns, something that traditional mutual funds can’t do. In more recent years, however, hedge funds are increasingly turning to these strategies in an attempt to achieve higher returns, and many feel that the original goal of hedging against risk has been lost. If anything, hedge funds are probably riskier than most mutual funds and index funds. In fact, recent news articles have been filled with stories of hedge funds going awry. For example, during the 2021 GameStop short squeeze, a hedge fund known as Melvin Capital lost over 50% of its value. During this same period, the overall market was up several percent. And more recently, a little known hedge fund called Archegos Capital completely collapsed, losing an eye-watering $20 billion dollars over the span of just 2 days, again from poor risk mitigation and overuse of leverage.
By the way, Melvin Capital’s minimum investment is reportedly $1 million dollars. Pretty steep barrier for the privilege of losing 50% of your money in 3 months during a bull market. These kind of requirements are not atypical for many other hedge funds as well. Hedge funds also charge high fees: they are infamous for a fee structure known as “2 and 20”, representing 2% annual expense ratio and 20% of annual profits. These kind of fees would be unimaginably high for any modern mutual fund, and only serve to line the pockets of the fund managers. In fact, if an index fund returns 10% in a year, a hedge fund would need to return 15% to match the index fund after fees! Because of this, it is difficult even for the fanciest of hedge funds to outperform a simple S&P 500 index fund. In 2018, Warren Buffet famously won a 10 year, $1 million dollar bet that the S&P 500 would outperform a hedge fund. Overall, hedge funds can be interesting products due to the variety of strategies they employ, but the results often fail to impress, and they are not suitable investments for the majority of investors.
Collectibles
This is a broad category of assets including things such as antiques, art, jewelry, cars, watches, trading cards, and even wine. These type of assets usually start off as consumer goods and only become valuable due to special circumstances. The vast majority of consumer and luxury goods are not appreciating assets, but rather depreciating ones. However, in rare cases, some of these goods do increase in value. This tend to happen with rare or limited edition goods which are incredibly difficult to obtain in the first place, or become scarcer over time. While some of these goods can provide significant return on investment, the market for them can be quite illiquid and speculative, and it takes a significant amount of experience to learn how to play these markets effectively. It is difficult for most people to invest in these goods in a consistent and repeatable manner.
I do have an article on the merits of luxury watches as investments. Give it a read if you’re interested in learning more about the high-end watch market.
I would advise extreme caution when “investing” in consumer goods rather than using them for their intended purpose. For example, some people may remember the Beanie Babie craze of the 1990’s, when certain stuffed beanie babies became hot commodities and were being flipped for 10x or even 100x of their retail value on the secondary market, such as eBay. People believed that the value of “retired” beanie babies would keep increasing, due to scarcity and demand. Like all bubbles, this one eventually burst as counterfeits flooded the market and consumer demand waned over time. If you bought thousands of dollars worth of beanie babies in 1995 hoping to cash out and retire, I’m sorry to say that your retirement plan probably won’t work in 2021.
Summary
Overall, the point of this article is to highlight the existence of alternative investments, in contrast to good ole’ fashioned stocks and bonds. As I said in the beginning, however, alternative investments are not necessary for a well-balanced and well-diversified portfolio, and many successful investors do not touch alternative investments of any kind. It is entirely possible to build significant wealth and achieve financial independence through only publicly available investments, as long as you have a well-constructed portfolio. This will be the topic of the next Investing 101 article, Portfolios and asset allocation. Thanks for reading and happy investing!
