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Alternative assets are seemingly all the rage, as everyone seeks high returns in assets that are not stocks, bonds or certificates of deposit. Here’s what you need to know about alternative assets and how to invest in them.
What are alternative assets?
Alternative assets are defined by what they’re not — they’re not stocks or bonds, and they’re not funds holding stocks and bonds. In other words, these assets are alternatives to traditional investment categories. While they’re non-traditional, these investments should have a history of holding — and ideally growing — value for investors.
The range of things seen as alternative assets is growing, but some basic types of alternative assets include:
- Art: Purchased directly from the artist or via a dealer or auction house.
- Undeveloped land: Direct holdings in land purchased through a broker.
- Real estate (residential, commercial, etc.): Held directly or through publicly traded REITs purchased on the stock exchange.
- Wine: Purchased directly from the producer or via an auction site.
- Currency, including cryptocurrency: Purchased on a currency exchange.
- Commodities: Stakes in oil, gold, crops, and many others can be purchased on an exchange.
The list goes on, and some people would include other options that they think have some enduring value, such as:
- Purses and handbags
- Sports and trading cards
- Other collectibles
While a financial advisor might steer you toward assets in the first list, those in the second list are highly speculative items that may lose their value at any moment on the whim of the market.
Pros and cons of alternative assets
So why do investors want alternative assets that aren’t traditional stocks and bonds? After all, the stock market as a whole has risen at an average annual rate of around 11% for decades. Isn’t that good enough?
The appeal of alternative assets has at least two parts:
- The potential for higher returns. First, the world of alternative assets is less picked over than the stock market, so there may be a great deal hiding in plain sight. Meanwhile, in the stock market, anyone with a brokerage account can buy a stock, and tens of thousands of professional analysts are looking for great deals, meaning there’s less probability of finding a great one.
- Prudent and diversified asset allocation. Second, alternative assets may not have a strong correlation with traditional assets such as stocks, which are highly correlated with other stocks. However, the prices of alternatives such as art may continue rising even when traditional assets are falling, providing diversification and a natural hedge against traditional assets.
Those are two of the major upsides to owning alternative assets, but there are potential downsides, too, and some can be quite negative.
- Lack of liquidity. Alternative assets tend to be less liquid than assets traded on an exchange. That’s both a benefit and drawback since it’s the lack of a ready market that presents the opportunity and makes it difficult to realize the asset’s value. For example, while stocks can be sold readily in the market, houses might sit unsold for months, even years. And there’s no guarantee that anyone will want that unique artwork that you purchased.
- Large spreads. Alternative assets often have a large spread between what a seller asks for the asset and what a buyer bids for it. This difference is called the bid-ask spread, and it can be huge depending on the market and how liquid it is. Fewer buyers mean that the asset is unlikely to be valued as highly as it could be, and any single buyer can drive a hard bargain for the asset, especially if the seller must unload the asset soon.
- High sales commissions. Another drawback of alternative assets is that sales commissions are often much higher than you’ll find for traditional assets. For example, while it may cost just a few dollars to sell hundreds of thousands of dollars of stock, the cost to sell a house of similar worth may be 6% of its value — potentially tens of thousands of dollars. Likewise, sales of art are often mediated by dealers and auction houses, who can take advantage of their privileged position and extract a tidy fee for their work.
How to invest in alternative assets
If you’re considering how to invest in alternative assets, you first want to understand the drawbacks over traditional assets and be completely comfortable with them. Most importantly, if your money is tied up in an illiquid asset, you may not be able to access it when you need it most. If you have to sell at a given moment, you may end up selling at a fire-sale price.
You’ll also want to consider how an alternative asset has performed across a market cycle or two. Has it gone up steadily? Has it declined when the stock market dipped? Is it likely to continue rising long term due to business reasons or overall popularity? In other words, is the alternative asset likely to fulfill its promise of diversification and acting as a hedge?
Real estate is one of the most popular alternative assets, and it’s also one of the easiest to access. If you’d like to invest in real estate, there are any number of ways to get involved. (Here are six of them.) The first step is understanding your market and how value is created in housing. From there, you can begin looking at residential properties that meet your criteria.
But there’s an easier way for would-be real-estate investors: real estate investment trusts, or REITs. That sounds complicated, but it’s not. REITs are publicly traded companies that own and manage real estate, and they’re popular for their large dividends. It’s easier than dealing with residential property yourself, and you have the benefit of the asset being highly liquid. You can sell the position immediately, without forking over 6% of the property’s sales price.
If you’re intent on buying alternative assets, start small. You want to get a feel for how they work and whether you’re comfortable with their drawbacks. Because these assets may also require specialized knowledge, it can take time to build up the know-how to make them profitable.
Finally, if you’re buying art as an investment, buy it because you love it, not because you think you can sell it for more later. This can be said for many other alternative assets as well.
If done properly, alternative assets can add diversification to your overall portfolio, helping balance out the swings of traditional assets such as stocks and bonds. But it’s important to remember that alternative asset is a catch-all term for a grab bag of assets. So be sure to select alternative assets that have a solid track record of performance, not merely because they’re different.