Risk of the Investment in the Alternative Asset Classes

Alternative assets can be classified as assets that are neither stocks, bonds, or cash, such as property, hedge funds, crude oil, sports cards, and gold. Interest in alternative asset investing has grown since the financial crisis. Investors are seeking greater diversification into assets that do not track the performance of stocks and bonds (Lamb). To illustrate, the Great Recession hurt stockholders and bond buyers with dropping share prices and lower yields on new bonds. But the price of gold rose from $800 an ounce in 2008 to more than $1,900 an ounce in 2011 (Voigt).

The average investor may never trade in any of these types of investments. The reason being is that they are often risky and lightly regulated, so it can be difficult to gain transparency on pricing and know whether the asset is worth what you are paying. Alternative assets are also less liquid and difficult to turn back into cash. Selling $1,000 in shares of a publicly traded stock is relatively easy while pricing and selling a $1,000 record album can be quite a challenge.

Get quality help now

Writer Lyla

Verified writer

Proficient in: Investment

5 (876)

“ Have been using her for a while and please believe when I tell you, she never fail. Thanks Writer Lyla you are indeed awesome ”

+84 relevant experts are online

Hire writer

Caution is required when investing in these asset types. Financial advisors recommend alternative investments make up no more than 10% of any financial portfolio (Voigt). They should not be treated as a substitute for stocks and bonds but more so as a complement to an investor’s overall portfolio by adding diversification features. Alternative assets for the common investor include real estate, private equity, commodities, and a relatively new phenomenon: peer-to-peer lending. Each of these asset classes have unique risks, returns, taxes, and liquidity and investors can benefit from being educated in each.

A popular type of real estate investment is REITs or Real Estate Investment Trusts. These investments were created by congress in 1960 to give everyone the opportunity to benefit from investing in income-producing real estate (Nareit). REITs allow anyone to own or finance property. In the same way shareholders benefit from owning stocks in other corporations, the stockholders of a REIT earn a share of the income without having to buy or finance property. The REIT industry has a diverse profile which offers many benefits. REITs often are classified in one of two categories: Equity or Mortgage. Equity REITs own a wide range of property types including offices, shopping centers, hotels, and apartments. They derive most of their revenue from rent on those properties. Mortgage REITs finance both residential and commercial properties. They earn most of their revenue from interest earned on investments in mortgages or mortgage backed securities. In addition, REITs can have their shares listed and traded on major stock exchanges. Regarding taxes, REITs are required to distribute at least 90% of taxable income annually to shareholders as taxable dividends (U.S. Securities and Exchange Commission). In other words, a REIT cannot retain its earnings. Like a mutual fund, it receives a dividend paid deduction, so no taxes are paid at the entity level if 100% of income is distributed. The following slide shows REIT performance during 2017. The REIT industry generated total returns of 9.3% last year. As you can see, the stock market significantly outperformed the REIT industry. The Russell 1000 Growth Index of large-cap stocks gained 30.2% while the S&P 500 Information Technology Sector returned a whopping 38.8% (Nareit). Graphs such as this appear to show a dramatic underperformance compared to the broad stock market. But this can be misleading for investors, especially risk adverse investors. The 2017 return of 9.3% is very close to the performance over the last 5, 15, 25, 35, and 45 years showing that these investments are predictable. Along with their reliability, REITs may well have been overlooked and undervalued in 2017, which gives an incentive to use these investments in 2018.

Another alternative asset common to investors is private equity. Private equity refers to company ownership by a specialized investment firm. Typically, a private equity firm will establish a fund and use it to buy multiple businesses with the goal of selling each one within a few years for a profit. This differs from publicly-held businesses where stock is bought and sold on an exchange and owned by a relatively large number of people. You probably recognize the companies on the following slide that received private equity funding at some point in time. Without the private equity funds, these companies may no longer exist. The funds raised by a private equity firm may be used to develop new products, make acquisitions, or strengthen a company’s balance sheet. Many private equity firms examine an underperforming business, and after purchasing the company, use their management expertise to improve profitability. Think of the local factory that has been shedding jobs for years. It has been falling behind its competitors and struggling with rising energy costs. The factory still makes a great product, but it needs a change in strategy and a capital infusion to compete with other factories. The private equity firm can provide the struggling factory with working capital, make critical investments, and upgrade its facilities. With new, more efficient equipment, the factory can reduce its energy cost and better compete with the global marketplace with the private equity firm reaping the benefits. So, if an investor is willing to put up quite a bit of cash, private equity can be a very prudent investment. The slide here shows the top five diversified private equity firms over the last 10 years (Artivest). Each firm has acquired and shaped big-name companies over time, most notably Hertz, Petco, and Alliance Healthcare.