Alternative Investments: A Look at the Pros & Cons

Once the domain of institutional and high-net-worth investors, alternative investments continue to grow in popularity and are making their way into the portfolios of retail (individual) investors.

Here are some of the pros and cons of alternatives and ways advisors are approaching these non-traditional investments for their clients. (See also: Top Alternatives to the Stock Market.)

Alternative investments typically don't correlate to the stock market, which means they add diversification to a portfolio and help mitigate volatility. They can also offer tax benefits not available in traditional investments.

Like any investment, the rate of return for alternatives is not guaranteed, but there is potential for it to be higher than that of traditional investments. Proponents of alternatives in the portfolios of individual investors maintain they now have access to sophisticated investments and potentially higher returns that until relatively recently were only available to institutions, such as pension funds and foundations, and the wealthy. (See also: ETF Alternative Investments.)  

Alternative investments are more complex than traditional investment vehicles. They often have higher fees associated with them, and they're more volatile than traditional investments such as stocks, bonds and mutual funds. The majority are invested in illiquid investments, making them difficult to exit and price on a regular basis.

As with any investment, the potential for a higher return also means higher risk.

Providing liquidity and price transparency that appeals to the average retail investor, liquid alternative investments have proliferated since the financial crisis in 2008.

Liquid alternative funds include exchange-traded funds (ETFs) and mutual funds that use strategies similar to hedge funds to mitigate risk. Their investments are typically not correlated to stocks and bonds.

Alternative investments such as private equity are also making their way onto 401(k) platforms. The underlying assets of private equity funds are generally illiquid and difficult to value, which creates a challenge when offering them in defined contribution plans. Defined contribution plans provide liquidity and prices daily on investment options offered to plan participants. To overcome liquidity and pricing challenges, private equity firms are looking to offer private equity exposure via target-date funds and collective investment trusts. (See also: Top Vanguard Funds for Retirement Diversification.)

Advocates of private equity as an option in 401(k) plans maintain that the average investor will now have access to the potentially higher returns that this type of non-traditional investment yields compared to the typical plain-vanilla options—like mutual funds and stock and bonds—from which they have to choose.

According to Strategy& (formerly Booz & Company), alternative investments will grow to $18.1 trillion worldwide by 2020. Part of the reason for this is that investment firms have lowered the entry requirements for mutual funds that are oriented toward alternatives. Also, investors themselves have developed a taste for something besides the usual mix of bonds, mutual funds and ETFs. Many emerging economies are switching from a savings-oriented approach to an investment approach, making themselves attractive to investors seeking new opportunities.

However, this outlook may be conservative considering the arrival of investing in cryptocurrencies such as bitcoin. This investment option could falter, but the amount of interest in it from institutions worldwide suggests that it could be a viable alternative for those seeking high-risk/high-return vehicles.  

Another investment that is attracting a lot of money is equity crowdfunding. Individual investors can purchase shares of a new company through online sites that offer these opportunities. This is a very high-risk investment because many new companies fail. But there are enough investor success stories to make this option attractive for even small investors.  

Alternative investments are becoming more popular for investors. Proponents of these non-traditional investments maintain the average investor will now have access to assets not correlated to the stock market, offering diversification and potentially higher returns when compared to mutual funds, stocks and bonds. Alternatives are complex and often higher risk than traditional investments to which most individual investors are accustomed. For financial advisors, education is key when it comes to recommending these investments for a client’s portfolio. (See also: Alternative Investments in Your IRA.)