Investors are taking a closer look at the world of non-traditional or alternative investments as a potential source of return and diversification. While stocks and bonds still have their place in portfolios, alternative investments seek to offer four potential benefits to a portfolio: diversification, differentiated income, capital preservation, and enhanced returns.

What exactly are alternatives? 'Alternatives' is simply an umbrella term to describe an asset or assets that don’t traditionally fall neatly into the equity or fixed income box.

An Introduction to Alternatives

Alternative investments exist within the private markets, with different strategies offering unique approaches. Before looking at the different areas, it’s worthwhile to note that when considering alternatives for a portfolio, just like any other investment, investors must understand the tradeoffs and risks unique to private markets. Many alternative investments require an investor to be known as accredited. To be classified as one, investors must match the following criteria:

• Investor has a net worth of over $1 million (excluding their primary residence)
• Or has an income of over $200,000 individually ($300,000 with a partner) in each of the prior two years and expects the same for the current year.

If the investor is accredited, then comes the characteristics of the investment vehicle itself. The right investment strategies and vehicles for portfolios are dependent on goals and risk tolerance. What works for one, won’t always work for another. It’s important to do proper due diligence to ensure that you understand the opportunities and risks associated with the vehicle. One example is that these investments are illiquid, meaning not easily sold or converted to cash, so careful consideration of the amount and the exact nature of the investment is needed when evaluating whether to add to a portfolio.

Six Strategies of How Alternatives Fit into Portfolios

Alternatives can be incorporated into a portfolio using the below six strategies.

1. Real estate: One of the more well-known types of alternatives - real estate properties - can have both fixed income and equity characteristics. The stream of rental income and the property appreciation can lead to a higher return, but the investor risks locking up capital in a property and may be forced to sell at an unfavorable price if the market takes a downturn.

2. Private equity: These types of ventures invest in the equity of companies that aren’t listed on an exchange. This may be at different points in the company’s lifecycle, whether they are startups or businesses looking to restructure or expand.

3. Private debt: Similar to private equity, private debt alternatives are not financed by banks or traded in the open market. Private debt is leveraged when companies need additional capital to grow their business. The investor makes money off the interest of these loans, and the return of capital on the repayment of the loan.

4. Hedge funds: These private investment funds can utilize several different strategies, depending on the fund manager and the exact market opportunities they are targeting. Hedge funds are exclusive, and only available to institutional or high-net-worth investors. Although they may be able to provide higher returns over the long term, money is often tied up for years and divestment is only available at certain times.

5. Commodities: Real assets and mostly natural resources such as agricultural products, crude oil, natural gas, and precious metals. Commodities are considered a hedge against inflation, as they have a low correlation with public equity markets and are instead dictated by supply and demand on the futures market.

6. Collectibles: This can range from rare wines to baseball cards and everything in between. Some common collectibles are fine art, stamps & coins, or vintage cars. These assets have the potential to appreciate over time but be aware that gains on these assets are taxed at a special tax rate.

The trends and opportunities within private markets are growing, continue to do your due diligence by understanding how alternative investments fit into portfolios in this article, 4 Reasons Portfolios Can Benefit from Alternatives.

Please consult with an attorney or a tax or financial advisor regarding your specific legal, tax, estate planning, or financial situation. The information in this article is not intended as legal or tax advice.