Alternative investments are assets that do not fall into the typical investment categories of equities, bonds and cash. If you are looking to diversify your portfolio, they are worth considering. They can generate big investment returns.
However, they are riskier than more mainstream assets and are unlikely to be suitable for beginners to investing.
Below, we cover:
- Where alternative investment opportunities can be found
- Investing in private equity
- Investing in hedge funds
- How to invest in alternative investments
This is module six of Investing for Intermediates, a course that gives you practical tips for investing.
What are alternative investments?
Alternative investment opportunities can be found in sectors including:
- Private equity
- Hedge funds.
They are popular with wealthy investors and institutional investors, such as pension funds, which are able to invest large sums of money on their clients’ behalf.
“Alternatives can be very volatile and difficult to analyse,” says Emma Wall, head of investment analysis and research at Hargreaves Lansdown. “Investors should focus on equities, bonds and cash for their core portfolio. Alternatives should only ever be an added extra; the spice in a meal – not the main event.”
Our guide to investment trends explains more about where to invest your money in 2022.
Private equity funds pool investors’ money to invest mainly in companies not listed on a stock exchange, in any and every sector.
They can also buy public companies and turn them private to boost profits.
Private equity takeover example
Supermarket chain Morrisons was taken private in October 2021 when bought by the US private equity fund Clayton, Dubilier & Rice for £7.1bn after a fierce bidding war with a rival private equity firm. This is the first time since 1967 that the UK’s 4th-largest supermarket chain is in private hands.
PE funds makes returns for investors in three steps:
- Buying a controlling share of at least 50% of a company
- Improving it to make it more profitable, by giving it money and/ or changing how it works
- Selling it to another private business or via a public listing within five years
Venture capital is a type of private equity that focuses on start-ups. Mainstream private equity tends to focus on more mature companies.
Pros of private equity:
- Private equity can put money into a wide range of companies, diversifying an investment portfolio.
- Can lead to big returns quickly, five years or less.
- Often minimum investment amounts are high – tens of thousands of pounds – and there is no guarantee of success.
- Less transparency around the inner workings of your investment.
- High fees at about 1.5-2.5%. Fund managers will also take a 20% cut of the profit.
Private debt investors lend money to companies, public or private, to improve their fortunes. It can also be called “private credit”.
The business must pay back the loan with interest, so investors receive a regular return from the interest payments. Unlike private equity, investors do not own a share of the company.
How private debt works: An example
FTSE 250-listed warehouse investor Londonmetric raised £380m of new debt in March 2021 from investors in the UK and North America. Investors will receive an annual return ranging from 2.06% to 2.43% over seven to 15 years. The money will be used to fund green property developments
Pros of private debt:
- Access to a wide range of companies, increasing diversification.
- Investors can expect a predictable, fixed payment based on the interest that is charged.
- Potential to produce higher returns than other debt securities such as bonds and gilts where yields are very low.
- It is an illiquid investment – it cannot easily be sold on or exchanged for cash.
- You ideally need substantial knowledge of the sector you are investing in, and the risks involved.
Hedge funds are privately owned investment companies targeted at wealthy individuals and institutional investors such as pension funds.
The main advantage of hedge funds is they can invest in anything to make a profit.
They are set up to profit from bad times and good times by “hedging bets” – they might hold shares in companies that give reliable returns whatever the state of the economy, like food businesses, while holding stakes in sectors like travel, that do well in better-performing economies.
Famous example of aggressive hedge fund investing
Hedge fund investor George Soros “broke the Bank of England” by betting against the pound when the UK was forced out of the European exchange rate mechanism in 1992, by using short-selling. He correctly bet the pound would fall so sold high and bought back low.
This strategy also applies to falling share prices.
Pros of hedge funds:
- Provide a way to diversify your investments.
- Flexible with their investment style and can use strategies such as short-selling.
- Can invest more aggressively than mainstream funds.
- Higher fees; 1.3% on average, plus a performance or incentive fee of about 16% taken out of the fund’s profits
- Riskier than mainstream funds, so more volatility in big wins or big losses.
- Higher entry threshold, you must be willing to invest a significant amount of money.
A real asset could be an investment in something physical, or an asset that is not physical in nature but still has a recognisable value.
- Land – perhaps with the potential for development.
- Intellectual property. This is an intangible asset where your investment is aligned with a brand’s identity.
- Commodities, like gold, or energy products such as crude oil or natural gas.
- Collectibles, such as artwork or fine wines.
- Real estate, including commercial buildings such as retail parks or office blocks.
- You own, or part-own, a physical asset and this can make it easier to value.
- You can enjoy, or have a connection with, the asset.
- Opportunities are unlimited and cover a wide range of sectors.
- A real asset is only worth what someone is prepared to pay for it, and can be difficult to value.
- It may be difficult to sell on if the asset class is a niche market.
- External factors such as government regulation may bring down the price.
How to invest in alternative investments
To invest in this area, it is best to speak to a financial adviser who can look into opportunities and carry out alternative investment management on your behalf.
You could also invest directly in companies that will pool your money with other investors to offer access to alternative investments. Examples include Madden Capital, which will invest your money across a range of sectors from a minimum starting point of £25,000.
Another option is alternative exchange-traded funds (ETFs), which give investors access to all the above asset styles from a lower price point. Examples include RPAR Risk Parity and iShares Physical Gold ETC.
When should I invest in alternatives?
The main benefit of alternative investments is that they allow an investor to diversify their portfolios into many sectors beyond mainstream investments such as company shares.
But alternative investments should only be considered by sophisticated investors and those willing to put in substantial sums of money.
Congratulations on completing our Investing for Intermediates course
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- Investment strategies
- Market trend analysis
- How to pick stocks
- Investing in dividend stocks
- Property investment strategies
- Alternative investments
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