Alternative investments? Alternative to what, actually? What we mean by alternative investments here are investments other than “traditional stocks, bonds, and cash.”

Even though these alternative investments have a longer history than “traditional” investments, they currently play a little brother role to the much larger stock and bond markets.

Alternative investments vs traditional

alternative investments types

Most traditional investments are publicly available to any investor who has money to pay for them. And they are liquid, which means they can be bought and sold when you wish, though not always at the price you would like.

Most alternative investments, on the other hand, are sold by broker-dealers or financial advisors. In most cases, you must meet net worth or income requirements to be able to invest and be willing to hold the investment for a specific period. It may be as long as ten years or more. That’s why the majority of these products are described as illiquid.

Though they share similarities, alternative investments are not all alike. There’s significant variety, just as there is among traditional investments. Especially in the ways, they generate returns and the levels of risk to which they expose you.

Alternative investment types

Public and private alternative investments

Some alternative investments are public and others are private. Public investments must register with the Securities and Exchange Commission (SEC) or the Commodity Futures Trading Commission (CFTC). Also, they must register with the securities regulator in the states where they are offered for sale. The sponsors must provide a prospectus or offer circular to potential investors and file regular financial reports. It inclides an annual audited Form 10-K with the SEC.

The relationship of an investment’s return to the return of its relevant benchmark is called its beta. When they’re similar, it is a positive correlation. When they’re not, it’s a low or non-correlation.

Private investments, on the other hand, are exempt from registration with a federal regulator. The financial reporting that’s required varies from product to product and state to state. All investments, public or private, are subject to federal and state anti-fraud regulations.

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Minimum investments

Most alternative investments set minimum investment requirements. It ranges from as little as $2,000 to as much as $2 million or more. Investors may be able to reinvest distributions from the investment to buy additional shares. Sometimes they may get it at a discount. With some alternative investments, there’s potential for appreciation at the end of a specific term, often seven to ten years though it may be longer. With others, the return is limited to cash distributions during the term.

Traded or non-traded

A traded investment is one that is listed on a public securities exchange, such as the New York Stock Exchange (NYSE) or the Nasdaq Stock Market, or on OTC market. In the case of stock, for example, trading begins following listing on an exchange. While trading in these securities may occur in many venues, your order to buy or sell one of them will be acted upon immediately in the case of a market order or as soon as the security is available at the price you specify in a stop, limit, or conditional order.

alternative investments how they work

Not all traditional investments are traded. Mutual funds are sold and repurchased by the investment company that sponsors them even when you purchase them through a broker-dealer. But alternative investments are rarely traded. The exception is alternative mutual funds, known as liquid alts.

A non-traded investment, on the other hand, is not listed on an exchange or sold OTC. Rather than an IPO, there is an offering period, sometimes rather lengthy, during which broker-dealers and financial advisors raise capital by marketing the product to eligible investors. Some types of investments, such as real estate investment trusts (REITs) and business development companies (BDCs), may be either traded or non-traded. The former are considered traditional investments and the latter alternative investments.

Understanding illiquidity

Lack of liquidity is often cited as a primary risk of investing in alternatives. What illiquidity means is that there’s no secondary market where you can sell the shares or units you have purchased even if you need the money. Some investment sponsors do have redemption programs. In other words, it may give you the opportunity to sell back your shares. But these programs aren’t required and those that may be offered can be suspended at any time. The sponsor may buy back only a limited number of shares at any given time. Moreover, the price they pay may be less than the actual value of the shares provided in your account statement.

alternative investments vs traditional

On the other hand, a primary attraction of illiquid alternative investments is that they can help diversify an investment portfolio. That’s because historically their returns have a modest correlation to the return on traditional investments. It is measured by a relevant benchmark, such as the 500 index for large-company stocks. Low correlation results because the factors that influence an alternative investment’s performance is different from those that influence traditional investment performance.

For example, the changing dynamic of supply and demand impacts the daily price of a traded investment. But in a non-traded investment share price may not fluctuate because there is no secondary market trading. Sponsors of alternative investments can benefit from illiquidity too. It happens because they have an extended period to turn a profit for investors.

Limited partnerships are a uniquely American business structure. They were created in colonial times, when the British refused to issue charters for new companies. Entrepreneurs, determined to move forward, pooled their capital and credit to share operational and financial risks. Their ingenuity laid the groundwork for what became formal partnership agreements.

In conclusion

A major difference between traditional and alternative investments is that traditional investments are traded on a securities exchange. At the same time, alternative investments are non-traded. They are offered directly to investors by broker-dealers and financial advisors.

If you buy stock in a publicly traded company, the return on your investment depends on whether the company is profitable. Also, it depends on whether other investors think the company is a good investment in the exchange marketplace. If many want to own it, the stock price will go up. As result, you can sell at a profit. But if they find another investment more attractive and sell their shares, the price will drop.

Thus, the performance of your investment has an exchange factor — an amplifier or dampener of sorts — in addition to the company’s performance. But if you make an alternative investment, you invest more directly in a company or project. Whether or not you make money on your investment depends primarily on the production of the company. In other words, it does not depend so much on an exchange marketplace where the other investors buy and sell control the value. There are advantages and disadvantages to both the traded and non-traded sectors. And explored those here.

Wishing you a great week!

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