What is an Alternative Investment Market?

ByMunyaradzi Mafaro

An alternative investment market is where people can buy and sell investments that are different from the usual stocks and bonds traded on the stock market. These “alternative investments” can include things like:

  • Hedge funds
  • Private Equity
  • Real estate
  • Commodities like gold, oil, and wheat
  • Collectibles like art, wine, or rare coins

Alternative investment markets give investors more choices besides just stocks and bonds. They operate under rules different from those of regular stock exchanges.

How Are Alternative Markets Different?

The most significant difference is that alternative markets are not as strictly regulated as the stock market. Companies listed on alternative markets do not have to follow all the same rules and reporting requirements as those on the leading exchanges, such as the New York Stock Exchange.

This means investing in alternative markets can be riskier since there is less oversight and public information about the investments. Conversely, fewer regulations can also mean more flexibility and potentially higher returns for investors.

Who Invests in Alternative Markets?

Historically, alternative investments were mainly traded by large, sophisticated investors such as:

  • Institutional investors like pension funds, endowments, and insurance companies
  • High-net-worth individuals and families
  • Professional money managers like hedge funds

However, alternative markets have become more accessible to everyday “retail” investors in recent years. Online trading platforms and investment vehicles like exchange-traded funds (ETFs) have made it easier for individuals to invest in assets like commodities and real estate.

Types of Alternative Investment Markets

There are many different kinds of alternative investment markets, each specializing in certain types of assets. Some of the major categories include:

Private Equity and Venture Capital

Private equity refers to investments in companies that are not publicly traded. Private equity firms pool money from investors to buy stakes in private companies or to buy out public companies and take them private.

Venture capital is a type of private equity that focuses on investing in startup companies with high growth potential. Well-known companies like Facebook and Uber relied heavily on venture capital to grow in their early stages before going public.

Hedge Funds

Hedge funds are investment pools that use complex strategies to deliver positive returns in both up and down markets. Common strategies include:

  • Long/short equity – Buying stocks expected to increase in value while also “shorting” (betting against) stocks expected to fall
  • Arbitrage – Exploiting price differences for the same asset in different markets
  • Global macro – Making bets on global economic and political events

Due to the risks involved, hedge funds are typically only accessible to “accredited” investors who meet high income and net worth requirements.

Real Estate

Investors can gain exposure to the real estate market without directly buying property by investing in securities like:

  • Real Estate Investment Trusts (REITs) – Companies that own income-producing real estate like apartments, offices, malls, and hotels
  • Real estate limited partnerships
  • Mortgage-backed securities

These allow investors to earn income from rents and capital appreciation of the underlying properties.

Commodities

Commodity markets allow investors to buy and sell contracts for physical goods like agricultural products, energy, and metals. Investors can speculate on commodity price movements or use these markets to hedge against inflation risks.

Major commodity markets include:

  • Chicago Mercantile Exchange (CME) for products like cattle, hogs, lumber and butter
  • New York Mercantile Exchange (NYMEX) for energy products like crude oil and natural gas
  • London Metal Exchange (LME) for industrial metals like copper and aluminum

Collectibles

Some investors allocate a portion of their portfolios to collectible items that have the potential to appreciate over time, such as:

  • Art
  • Antiques and collectibles
  • Fine wine
  • Precious metals like gold and silver

The collectibles market is highly specialized and illiquid compared to other investment markets. Values can be very subjective based on trends, rarity, and collectors’ specific tastes.

Advantages of Alternative Investments

Including alternative investments in a portfolio alongside traditional stocks and bonds can provide several potential benefits:

Diversification

Alternative investments tend to have a low correlation with the stock and bond markets. This means they don’t always move in the same direction as stocks and bonds, which can help mitigate overall portfolio volatility and risk.

For example, commodity prices often rise with inflation while stock prices may fall, so holding some commodities can be an inflation hedge.

Higher Potential Returns

The reduced liquidity and higher risks of alternative investments mean they also have the potential for higher returns than traditional assets. The performance of alternative assets like private equity and venture capital has outpaced the stock market over the past several decades.

Access to Unique Opportunities

Alternative markets give investors access to a wider range of investment opportunities beyond public companies and government bonds. Investors can tap into the growth of emerging industries and companies or stake in unique, tangible assets like real estate and artwork.

Risks and Drawbacks

Investors need to be aware of the risks and limitations of alternative investments compared to traditional markets:

Less Liquidity

Many alternative assets are highly illiquid, meaning they cannot easily be bought or sold like stocks. It may take time to find a buyer for a stake in a private company or a piece of real estate, making it harder for investors to cash out of their investments if needed.

Less Transparency and Higher Fees

Because alternative markets are more loosely regulated, there are fewer reporting requirements around pricing, valuations, and trading activity. This lack of transparency makes it harder for investors to get a clear picture of performance and risks.

Alternative investment vehicles also often charge higher management and performance fees than mutual funds and ETFs. “Two and twenty” is a standard fee structure, meaning a 2% annual management fee plus 20% of profits.

More Complexity and Volatility

Alternative strategies are much more complex than buying stocks and bonds. It can be challenging for individual investors to thoroughly evaluate the risks of different alternative investments. Values can also be highly volatile based on niche factors and sporadic trading.

Regulation of Alternative Markets

While public stock exchanges are heavily regulated by government agencies like the Securities and Exchange Commission (SEC), alternative investment markets have traditionally been subject to much looser oversight.

However, regulatory scrutiny of alternative markets has increased in recent years following the financial crisis and headline-making frauds like the Bernie Madoff Ponzi scheme.

Regulations vary across different alternative markets, but some essential rules include the following:

  • Limiting certain investments like hedge funds to “accredited investors” with high incomes or net worth
  • Registration and reporting requirements for some private funds
  • Rules around disclosures, pricing, and valuations
  • Oversight of trading venues and market participants

Should You Invest in Alternative Markets?

Whether alternative investments are suitable depends on your financial situation and goals. Potential investors should carefully consider factors like:

  • Your income and net worth
  • Investment time horizon
  • Risk tolerance
  • Need for liquidity
  • Familiarity with complex investment strategies

Many financial advisors recommend limiting alternative assets to a relatively small part of an overall portfolio, such as 10-20%, with the core holdings still in traditional stocks and bonds.

Thoroughly research and understand any alternative investment before committing money. Ensure you are comfortable with the risks, fee structure, and liquidity constraints.

Investing in a diversified mix across different alternative markets can help mitigate the risks of any particular asset class or strategy. Consider starting with a small allocation and building it gradually over time.

Munyaradzi Mafaro is a music enthusiast and he also likes to tackle topics of business, productivity, and the possibilities for growth in the digital world.