Alternative Investments; Part 1: Overview of Alternative Investments

Alternative investments are financial assets that are not the traditional investments such as stocks, bonds, debt securities or cash. They are held by an institutional investor because of their complex nature, regulation and degree of risk. Examples of alternative investments include venture capital or private equity, mutual funds, hedge funds, private debt, real estate, alternative currencies and commodities. These investments are illiquid.  This is because of the absence of a market and low demand. Think about how hard it would be to sell a precious metal or a vintage car compared to stocks. They are also not traded on the stock exchange market so are not overseen by the Securities and Exchange Commission. Also, there are other alternative investments options such as art, rare wine vintage cars.

Have you ever found yourself in a random group chat with several pictures and voice notes talking about a particular investment with ridiculously high interest rate that feels too good to be true? Have you ever heard the words, “20 years ago, a plot of land in Lekki costs N5,000 now it is over N50,000,000, buy land today”. While it is true that land appreciates, nobody talks about the high recurring cost of operations apart from the actual cost of the landed property. Alternative investments are prone to scams and fraud due to the unregulated nature and unclear structure. It seems like everything is termed an investment these days and if one is not careful, they would fall into a trap and incur heavy losses. It is gravely important to gather as much information as possible before investing. It is pertinent to conduct extensive due diligence.

These are the various categories of alternative instruments:

Private equity: they are private investments made to private companies that are not listed on the stock exchange. The two parties are the investing firm and the company receiving capital. Capital could be financial, expertise, intellectual, e.t.c. Private equity includes venture capital; which focuses on start-ups and early ventures, growth capital; which focuses on expanding or restructuring mature companies and buy outs; purchase of a business or a business unit.

Mutual funds: they use pool funds collected from investors to invest in securities, bonds, stocks and other assets.

Hedge funds: they use pool funds that employ aggressive strategies to achieve high returns. They are expensive and usually available to institutional investors.

Pool Funds: these are funds grouped in a portfolio for investing. It is for diversification of risk and return.

Private debt: these are not financed by banks or traded on the stock market. These companies issue capital as debt that would be paid back with interests. They provide capital to businesses that need additional capital.

Real estate: this is a common alternative asset and available in all corners of the world. It ranges from farmlands to vineyards to residential property.

Alternative currencies: these comprises of any currency other than government issued currency. It includes cryptocurrency, bitcoin, litecoin and so on.

Commodities: there are soft and hard commodities. Soft commodities cannot be stored for a long time e.g. cotton while hard commodities include metals, wine, vintage cars.

According to Preqin (2018, pp. 5), a research firm in London explained that alternative investments industry is one of the fastest growing fields in finance and is expected to grow 59% by 2023. The blessing with alternative investments is that they allow minimum investments and low transaction costs e.g. mutual funds. However, a few of them require high investments such as venture capital. This helps to regulate the cash inflows. It is also a way of controlling the number of investors. They usually vary drastically based on the type of investment. They generally used to be limited to high net worth individuals and institutional investors but now individuals and small scale investors have the opportunity to invest. They are also a suitable tool for portfolio diversification which mitigates losses. Land, for instance is a tool against inflation. In the long run, they produce high returns which is why they are mostly bought to hold rather than to sell. Since they have a low correlation with the stock market, even during a market downturn, risk is reduced.

A con of alternative investments is that it is hard to determine their value. Valuation of alternative investments are somewhat complicated and require specific knowledge. This is also due to their unique nature e.g. gold. It also has to be held for a long time to earn maximum returns, ranging from 5 years.

In the following weeks, we will discuss in detail these categories of alternative investments and how to exercise due diligence on alternative investments.

References

Preqin. (2018). the future of alternatives (E-book).https://www.preqin.com/

Chen, J. (2020, March 6). Alternative Investment Definition. Investopedia. https://www.investopedia.com/terms/a/alternative_investment.asp#:%7E:text=Key%20Takeaways-,An%20alternative%20investment%20is%20a%20financial%20asset%20that%20does%20not,all%20examples%20of%20alternative%20investments

Chladek, N. (2020, May 7). 7 Types of Alternative Investments Everyone Should Know | HBS Online. Business Insights – Blog. https://online.hbs.edu/blog/post/types-of-alternative-investments

Landry, L. (2020, April 28). What Are Alternative Investments? | HBS Online. Business Insights – Blog. https://online.hbs.edu/blog/post/what-are-alternative-investments

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