Alternative Investments: Definition, Examples, and Role in a Portfolio

The traditional investment avenues that come to mind when most people think of investing are cash, stocks, and bonds. These conventional assets, like the index fund in your mutual fund portfolio or the cash in your savings account, are typical for most individual investors.

Beyond traditional investments, there is another type of investing known as alternative investments. As the phrase suggests, these are the alternatives to the traditional, and rightly so, have alternative benefits.

Asset classes that are not included in conventional investing categories, like stocks, bonds, and cash, are referred to as alternative investments. These investments can contain a wide variety of assets, from P2P lending to expensive art pieces, from commercial real estate to farmland investing, and many more.

Alternative investments are primarily used to diversify portfolios, boost returns, and reduce risks associated with a large concentration in traditional assets. Alternative investments have recently gained impetus and popularity with several online platforms mushrooming in this space. Today, the Alternative Investment Funds market is expected to grow by over 25% CAGR between 2022 and 2025, testifying the boost. Globally, the alternative investment market is expected to double in size by 2027!

In this post, we’re going to understand what are alternative investments, and how they work. Let’s start by looking at a few different types of alternative investments.

Key Examples of Alternative Investments

1. Peer-to-Peer (P2P) Lending:

Function: Provides investors with high, steady income via monthly interest and principal payments. Risk Profile: Moderate, managed via diversification. Regulation: RBI in India. P2P investment platforms like IndiaP2P give you an opportunity to assess and invest in credit-worthy borrowers, through their data-backed interface.

2. Real Estate Investment Trusts (REITs):

Function: Allows investment in commercial property without buying the asset. Risk Profile: Moderate to High, market-linked. Regulation: SEBI in India.

3. Private Equity and Venture Capital:

The wide term "private equity" refers to financial investments made in privately held businesses or those that are not publicly traded on a stock market like the NSE or BSE.

Private equity is divided into a number of categories, including:

• Capital for startups and early-stage businesses, known as venture capital.
• Growth capital, which aids more established businesses in growing or restructuring.
• Buyouts, which occur when a business or one of its subsidiaries is completely acquired. 

The partnership between the investment business and the company receiving funds is a key component of private equity and often goes to the level of tussles in management.

Private equity is a costly affair and is out of reach for average investors owing to high ticket sizes going in millions of dollars. However, there are ways to invest in booming startups that investors can now benefit from, for as little as a few thousand Rupees.

4: Hedge Funds:

A high return on investment is the main objective of hedge funds, which are investment funds that trade reasonably liquid assets and use a variety of investing strategies.

To implement their strategies, hedge fund managers might become experts in a range of disciplines, including long-short equities, market neutrality, volatility arbitrage, and quantitative methods.

Only institutional investors, including endowments, pension funds, mutual funds, and high-net-worth individuals, are permitted to invest in hedge funds.

5: Commodities:

Natural resources make up the majority of commodities, which serve as assets and inflation hedges. Due to supply and demand, their prices change, which is advantageous to investors.

6. Collectibles:

Collectibles come in a variety of forms, including unique wines, mint-condition toys and fine art, cards, and everything collectible! 

Purchasing and preserving tangible assets in the hopes that their value will increase over time is the definition of investing in collectibles.

7. Structured products:

Structured products typically include derivatives or securities whose value derives from an underlying asset or collection of assets like stocks, bonds, or market indices, as well as fixed-income markets. These include market-linked debentures that are based on market indices for their performance.

8. Monthly Income Plan From Alternative Investing

Alternative investing has two key sides to it, earning regular cash flows, and appreciating the underline asset value.

A monthly income plan is an investment strategy that tries to provide investors with consistent income. Investing in assets with consistent cash flows, like rental properties, or debt instruments like P2P, is usual for this strategy.

Key Features & Regulation of Alternative Investments

• Risk-Adjusted Returns:

Alternative investments face risk variance, requiring regulation-based risk-adjusted performance measures of ratios and matrices to assess investment risk-reward profiles.

Risk-adjusted returns basically refer to the expected returns from an investment after discounting the associated risks.

Understandably, different alternatives have different risk-reward profiles, and your investment decisions must depend on your risk appetite.

• Minimum investment requirements:

Alternative investments have traditionally been unsuitable or inaccessible for the average investors due to high capital commitments and liquidity risks. Regulatory authorities often set minimum investment criteria to protect investors from potential losses.

However, the fintech revolution has witnessed a commendable democratization of these asset classes, lowering the ticket sizes, and alleviating the information asymmetry.

• Correlation:

Alternative investments are less susceptible to market fluctuations than traditional assets because of their low correlation. What this means is that the alternatives do not fluctuate in sync with the traditional markets.

A slump in the stock markets may be reciprocated by an unusual growth in the real estate segment. Additionally, certain alternatives have historically acted as a hedge against inflation.

• Liquidity:

Liquidity in alternative investments is typically lower than in traditional investments like stock markets, due to lock-in periods and longer investment horizons.

For example, Private equity funds may hold money longer, requiring more patience from investors.

However, as more and more investors are jumping in, owing to accessible online platforms, the liquidity woes of alternatives are gradually being subdued.

• Regulations:

In India, Alternative Investment Funds or AIFs are regulated instruments that allow investors to pool their money and invest in a bunch of alternative asset classes. The AIFs are strictly regulated as per the provisions of the SEBI (Alternative Investment Funds) Regulations, 2012. AIFs are legally classified as Category I, Category II, and Category III AIFs depending on the underlying asset classes.

Other than the AIF Regulations regulating the funds, individual alternative asset classes are also watched over by several regulatory authorities like the Reserve Bank of India or the Securities and Exchange Board of India. For instance, the RBI watches over P2P lending and investment platforms in India, in accordance with its 2017 directions.

Conclusion:

For investors looking to diversify their portfolios and perhaps earn good returns outside of established asset classes, alternative investing has become a promising option.

Alternative investments have the potential to offer returns that are uncorrelated to those of traditional markets, thereby lowering total portfolio volatility and improving long-term performance.

But because alternative investments frequently carry higher levels of risk, illiquidity, and varied degrees of complexity, it is vital for investors to approach them cautiously.

In the end, investors must stay updated on new opportunities and regulatory developments to effectively manage risk and capitalize on these opportunities. At the end of the day, it’s you who needs to decide what’s the best investment for you, and how you can maximise your returns on investments.