Alternative investments cover a huge range of assets from commodities to wine. They are alternatives to conventional investments that are essentially listed securities, cash and bank deposits and lending.
They are, therefore, largely defined by what they are not, rather than what they are. It is often claimed that their other defining characteristic is a low correlation of returns with conventional investments. This means they can improve diversification, which is a key motive for investing in them.
Examples of alternative investments include:
- commodities,
- hedge funds,
- private equity,
- collectibles (such as stamps, art, antiques, etc.),
- wine.
Looking at this list, another common characteristic of alternative investments many become apparent: they are less accessible to small investors then securities. They are often illiquid, require large amounts to be invested, and may be barred by regulators from sale to the general public.
The inclusion of hedge funds may look odd, as they usually do invest in listed securities. However, because they usually employ market neutral absolute return strategies their returns should not be correlated with those of the markets they invest in — hedge funds can make money in falling markets.
Private equity is likely to have some correlation with equities markets, because markets are used to exit investments (e.g. through an IPO), and with bond markets because they provide finance. However the long term, the focus of certain types of business, and the dependence of returns on making changes to companies invested in do reduce this somewhat.
Commodities are volatile and speculative investments. Unlike most conventional investments, there is no built in growth (given inflation, it is more accurate to say no built in growth in real terms. Debt pays interest, equities represent a business that makes a profit, but commodities are an investment in unused assets.
This is also true of collectibles. In addition, collectibles are tricky to value, because there are no real fundamentals to value them on. The real fundamental is how much collectors are willing to pay, regardless of investment potential. Once a premium starts to be paid for their investment potential, the value becomes very speculative, akin to premium paid on securities during a bubble on greater fool speculation. This happened, for example, to stamps in the 1970s, and has happened in parts of the art market.
Wine does often gain some value through ageing, which is what sets it apart from collectibles. It does, like them, require specialist knowledge.
Alternative investments can improve both returns and diversification, but the risks are considerable. Their value may plummet as fashions change (collectibles), as the behaviour of markets changes in ways that makes particular strategies unprofitable, and from drivers unique to that type of asset. Without fundamental analysis, or much in the way of regulation, they also tend to be vulnerable to hype and manipulation.