Perhaps the most misleading term in finance is "alternative investments." It refers to investments in anything besides stocks and bonds. Considering people have been investing in real estate, precious metals, agricultural commodities, and private lending since the dawn of recorded history, and in stocks and bonds only since about 1600, one is left to ponder which is really "alternative."
Still, we are constrained by the terms of art, and such innovations of more recent vintage as hedge funds, cryptocurrency, and carbon credits are also considered alternative investments.
It is impossible in the time allotted to delve deeply into all aspects of "anything besides stocks and bonds." Still, we will endeavor to outline the typology, terminology, benefits, risks, and funding vehicles of alternative investments. This, we hope, will provide you with vocabulary to discuss these topics in greater depth and perhaps increase your interest in this wide-ranging topic.
It is inherently interesting for empirical reasons, if for no other. Those who invest entirely in stocks and bonds might well be fooling themselves if they believe their portfolios are well-diversified. According to the Securities Industry and Financial Markets Association, the market value of the worldwide stock market is around $111 trillion, and that of the bond market is $119 trillion. While these are staggering numbers -- it is both true and unsettling that either exceeds the world’s gross domestic product -- they are dwarfed by the value of commodity futures alone.
History is never complete, nor can it ever be completely known. If we are discussing the development of alternative investments, though, perhaps it is instructive to parse them as dating from before the advent of publicly traded stocks and from since that time.
Investing is old -- far older than paper money. Agricultural futures date back to at least the time of Babylonia’s King Hammurabi, 4,000 years ago. On the other hand, cash didn't develop until about 1,200 years ago -- an innovation of China's Song dynasty.
Agricultural futures were critical in the development of early civilizations because they enabled farmers to acquire seed and livestock, which they could, months later, finally bring to market. Although they have become more commoditized and securitized over the centuries, they still serve the same function.
Of course, agricultural futures are predicated on the existence of agriculture, and farming had been the way of life for residents of the Fertile Crescent for 8,000 years before Hammurabi. Whenever someone attains anything of value, though, there will be others wanting to take it away. It wasn't long before the ability to defend property became a prerequisite for owning it. As human society became more complex, that requirement evolved from physical defense to legal defense, but, at heart, that just really means the local constabulary stands in for private armies. It is worth noting that, in Semitic languages, the words for "war" and "bread" come from the same root.
Humanity's obsession with precious metals is even older than its obsession with land. According to Gold-Eagle, members of the Cro-Magnon culture or something very much like it was collecting gold in their caves 40,000 years ago. Interestingly, there's no proof that people worked with it as a material for tool making or artistic embellishment until about 8,000 years ago. It is often taught that gold's initial value comes from its properties as a malleable yet dense metal that is among the least reactive yet most easily alloyed. Early humans valued it because it was shiny and rare and only later learned to craft it. Its inherent value, then, was as nominal then as it is now.
The oldest legal papers extant include a real estate deed found in the Palestinian West Bank, dating back around 2,500 years. Even so, real estate transactions were carved in stone as early as 4,600 years ago.
It is important to note that there were no banks at the time, although merchants' associations served the lender role to some extent. By the height of the Roman Empire, these proto-banks had begun accepting deposits and charging interest. Still, the experience of the transaction remained more similar to a private loan than a bank loan and even further removed from an issuance of public debt. One of the most frequent uses for lending at this time was to finance ships.
One other investment that traces its way back to the dawn of history is collectibles. It seems to have originated in roughly the same time and place as agricultural futures. Around the time when the West Bank real estate deed was signed, the greatest collection of the Classical world was being established: the Library at Alexandria.
Painting and sculpture were, as is well known, art forms familiar to the ancients. We know that these objects decorated homes and places of worship. Still, we lack evidence that sculptures were collected formally until the Renaissance, when Florence's Medici family gained fame as patrons of the arts. The family's art collection dates back to the 1400s and, by the 1600s, one no longer had to be as wealthy as the Medicis to indulge this impulse. According to Brown University Professor Steven Lubar, those considered upper-middle-class today began to establish mini-museums in designated rooms in their homes. These salons came to be called cabinets of curiosities and contained artwork and artifacts of geology, zoology, oceanography, and other nascent natural sciences.
This brings us up to a point in the timeline when stocks and bonds became publicly traded. While there have indeed been significant changes in what has become known as "traditional" investments over the past four centuries, there have undoubtedly been more changes to what has become known as alternative investments.
The old standbys continue to shine: real estate, commodities futures, precious metals, and collectibles. The markets have become more sophisticated, and, in many cases, investors are trading in securities derived from these underlying assets rather than the assets themselves.
Still, the universe of alt assets continues to grow.
Surprisingly, private equity is a relatively recent invention. Ever since the earliest craftsmen opened their shops, doubtlessly, individuals with money to spare have bankrolled independent businesses to expect a proportional share of the profits. We discussed earlier how private debt worked in ancient times, but private equity issuance did not catch on until the 20th century, according to Derek Loosvelt at Vault. It was invented in 1907 by American financier Henry Phipps when he created the Bessemer Trust. The company has since broadened its portfolio, but private equity remains the cornerstone of its operations.
In the intervening decades, this asset class has bifurcated into venture capital -- the funding required to nurture small, young growth companies -- and what we know today as private equity, which is most frequently used to buy out large, established public companies.
Private equity and venture capital generally take the form of pooled funds raised from wealthy individuals, family offices, and financial institutions, but that does not mean funds, in general, are alternative investments. Those chartered to invest strictly in stocks and bonds on behalf of retirement plan participants or other retail investors cannot be considered as such. Units of many of these funds are traded on stock exchanges exactly like public equity shares.
A close cousin to the exchange-traded fund, or ETF, is the real estate investment trust, or REIT. While contributing directly to a real estate development project or a property management company, or a home mortgage would be examples of alternative investing, buying REIT units is not substantively different from buying shares of stock. While there is an inherent risk in real estate investing, and this risk extends to REITs, these securities trade alongside shares of even more speculative companies.
Even as Wall Street has found ways to enable certain alternative investments to conform to mainstream investing norms, technology has enabled an explosion of digital-native instruments. The most obvious example is cryptocurrency. Still, in its preteen years as of this writing, this digital asset class purports to be the next step in the evolution of money itself. If that were currently true, of course, it would not be considered an alt because money is not an alt. At the moment, cryptocurrencies are chains of digital signatures of dubious underlying value and a minefield full of risks, so it is best to consider them as alternative investments.
The same blockchain technology which enables cryptocurrencies also enables non-fungible tokens or NFTs. While one cryptocurrency coin is much like any other on the same chain, each NFT is unique. As such, it can represent a work of art, a musical performance, a commemorative event, or some other one-of-a-kind object or experience and appears to be emerging as an evolutionary leap in the collectibles space. As with cryptocurrencies, though, it is still early days, and multimillion-dollar NFT auctions could prove to be a fad. In both cases, there is cause for both optimism and skepticism, and time will tell.
Another technologically enabled alt is undoubtedly here to stay, though: crowdfunding. It was made possible by the advent of the internet and given the regulatory green light by the Jumpstart Our Business Startups Act of 2012. The JOBS Act permits firms to raise money via crowdfunding without the compliance burdens required by the 1933 Act. And if they are simply pre-selling product orders or offering enthusiasts memorabilia for their generosity, then there is little in the way of compliance concerns. If they are indeed issuing equity via crowdfunding, they must float it on a regulated platform directly or indirectly by the Securities and Exchange Commission.
Now that we have discussed alternative investments in broad terms, we will now delve into the current state of today’s leading assets. These can be broken down broadly into two categories: financial assets and utile assets. We break out real estate separately because it could credibly be attached to either camp.
Along with describing each asset class, we will attempt to list the approximate current market value or trading volume, then note where we can acquire them and what agency regulates it.
The list of asset classes is drawn from the author’s previous work for the blog of Sharestates, an alternative investment platform specializing in real estate crowdfunding, and his work for the American Estate & Trust blog. This list is not, and could never be, exhaustive. Still, we believe it represents the vast majority of value held in alternative investments.
While financial assets tend to be more liquid than utile ones, such is not always the case. The term “alts” has come into use to describe those alternative assets which offer some degree of the liquidity one would expect from exchange-traded securities. Since there is no clear delineation between alts and other financial alternative assets, we list them here in order of what we perceive to be their degree of liquidity.
Hedge funds are accounts that have been pooled to trade in liquid assets utilizing novel strategies intended to beat the market. This increased return suggests increased risk, which they manage through such financial engineering tools as short selling, leverage, and strategic use of derivatives. (It is important to note that such derivatives as options and swaps are not themselves alts, while virtually any retail brokerage account allows the holder to short-sell as well as buy on margin.) In the U.S., hedge fund participants must be either institutional investors or what the SEC has deemed an accredited investor. Individual investors can be considered accredited if they meet at least one of these three criteria:
The hedge fund industry’s total assets under management as of this writing is approximately $4.1 trillion, according to BarclayHedge. Hedge funds are regulated by the SEC under Regulation D of the Securities Act of 1933. Since these funds can only market to accredited investors and institutions, it might make sense to approach them via their industry groups: the Hedge Fund Association and the Alternative Investment Management Association. New investors might be asked to participate in a “feeder” fund rather than the main fund; this is standard practice.
While each source for this section has its typology, we maintain there are three broad categories of commodity futures trading around the globe:
We are deliberately not including equity and fixed income futures in this list. Although it is our assessment -- reinforced by CME Group data -- that the value of these would swamp the value of all other commodities in terms of daily trading volume, it would have the effect of including the value of the underlying traditional investments in our review of alts. We should further note that interest rate futures are widely traded. However, speculators play a crucial role in that market. Financial institutions and industrial companies mainly use it to reduce risks related to inflation and foreign exchange fluctuations.
There is scant data available about the sum-total size of the commodity markets. Still, Comdex -- a blockchain-native commodity trading platform -- estimates its annual trading volume at $20 trillion and its actual value at "hundreds of trillions of dollars." Much of that value is held by and traded through managed futures accounts, which are essentially hedge funds chartered specifically for commodities. BarclayHedge puts global assets under management for these accounts at $319 billion.
The Commodity Futures Trading Commission regulates commodities in the U.S. The leading exchanges for agricultural futures are:
Other essential trading floors include:
Cryptocurrencies, as stated above, are not actual currencies in that they are too volatile to function effectively as a store of value and that there are not enough merchants who permit their customers to use them as a medium of exchange.
It is often said that these digital tokens cannot be considered money because they lack the imprimatur of sovereign governments, but this is a misguided argument. At many points throughout history, the U.S. and most other nations operated without a central bank. This left it to privately held banks or merchant associations to issue currency before the advent of modern banking. Our current conception of sovereignty is even younger than the oldest stock exchange. The Westphalian Peace treaty of 1648 defines the contours of independent statehood, and the Amsterdam Stock Exchange was founded in 1602. It is also true that metal coins had been used as a currency for about two millennia before a king's face was first engraved on one.
There are two main requirements for an asset to function as money (assuming that people agree to use it as such).
In the early 1990s, distributed ledger technology -- known more widely as blockchain -- emerged as an academic discipline favored by cryptographers. By late 2008, a pseudonymous party known as Satoshi Nakamoto published a white paper describing how a set of digital signatures -- called a coin -- could function as a reward to participants in a network for ensuring consensus around transaction recording. The function of this network would be to take friction and expense out of cross-border transfers of value. Whether or not Satoshi intended their “bitcoin” project to become a speculative alt is another question -- we have our doubts -- but that is what it has become.
Now there are thousands of cryptocurrencies. Some are intended to act as much like true currencies as possible, while others have unique utilities or use cases. Some, however, are remnants of failed and abandoned projects, while others are unabashed scams. According to cryptocurrency market source CoinMarketCap, the total market value of the asset class exceeds $1.4 trillion, of which Bitcoin Core holds a 46% plurality.
It is currently regulated by a platoon of six federal agencies in the U.S., as officials continue to ponder whether cryptocurrency is more like currency, commodity, or equity.
The most popular cryptocurrencies can be purchased via PayPal or such digital-native broker-dealers as Robinhood. SEC-chartered exchanges, including Binance and Coinbase, offer a broader, curated array of tokens. The CFTC has also approved LedgerX as a platform for trading cryptocurrency futures and options.
Decentralized exchanges, or dexes, are stateless actors unregulated by any governing authority but have virtually unlimited lists of asset pairs and allow for much easier leverage terms than the SEC would allow. While it is a relatively simple technological feat to trade on dexes from the U.S., it is illegal.
As discussed previously in this space, “private placement is the process companies use to raise money by selling securities to a limited number of potential investors. These offerings are designed to be exempt from federal securities registration requirements and, thus, from the compliance hurdles incumbent upon public offerings.”
That post, which focused on private placement, notes that all individual participants generally need to be accredited investors (as described in Reg D). The one exception is Rule 506(b), which allows issuers to sell market securities publicly and to accept funds from up to 35 non-accredited investors.
There are different rounds of private equity, each one suited to a different moment in a young company’s development. Not all companies require all rounds.
Pre-seed: This round is characterized by the absence of institutional investors, and there are several forms it can take.
Friends and family: The first people new founders might approach are their friends and family. The investment community has come to regard the friends and family around as a customary pre-seed activity. The standard instrument issued is the simple agreement for future equity, or SAFE, note. If the company takes off, each participating friend or family member will have the opportunity to convert the note to equity and enjoy all the upside benefits. If the company folds, then the SAFE is retired as a loan that will not be paid back.
Crowdfunding: SAFE notes are also the currency of most platforms chartered under Rule CF of the JOBS Act so that crowdfunding can be conflated with the friends-and-family round.
Angel: This is the point where wealthy individuals fund what they might consider a passion project rather than a conventional investment. This phase has gotten more sophisticated in recent years, with angels who had once invested as individuals pooling their funds to form an angel investor group, through which investment decisions are made by committee.
Seed: Once a company reaches a certain level of maturity -- usually following a demonstration of its ability to generate revenue -- institutional players become more willing to fund its path through the next gate. These often take the form of such incubators as Plug and Play Tech Center or Y Combinator.
Venture: Once a company has proven its mettle through the pre-seed and seed stages and now needs well in excess of $1 million in investment, it might now be ready to take on the responsibility of being part-owned by venture capital funds. While these investors have more money to offer than any founder is likely to need, this cash usually comes with a loss of company control. VC firms generally act as the active general partner and structure their acquisition funds so that institutions and accredited investors participate as limited partners. According to an excellent McKinsey study, VC firms worldwide have more than $1.2 trillion in AUM. Any one of a dozen might be among the largest on any given day, whether measured by AUM, the number of companies within its portfolio, or "dry powder" -- the free cash available with which to make acquisitions.
The next step up from the venture capital community regarding the amount of capital available to invest is private equity. PE refers to investment funds -- usually set up as limited partnerships -- which buy companies that are not publicly traded. According to Private Equity International, the top 300 firms account for $2.3 trillion AUM, led by Blackstone Group’s $93.2 billion.
The most famous (or infamous) instance of private equity was the leveraged buyout firm. While these were en vogue in the 1980s -- Gordon Gekko from Oliver Stone's Wall Street was the corporate raider at the head of an LBO operation. At the time, the model assumed that the management of an underperforming company was less than optimally efficient and that a financial buyer could come in, trim the fat, perhaps merge it with an industry rival, and benefit from its ownership stake in a leaner, better-focused company. This was met with mixed success and was already passé by the 2008 financial crisis, which signaled the end of the corporate raider era. Today PE funds more frequently advise companies on management buyouts, friendly changes in control, and special situations that present an obvious need for restructuring.
The advent of the JOBS Act caused an ever-increasing market for private loans (on both sides of the transaction). This is true for both business and personal notes. The only barrier to entry is the lender’s supply of liquid funds. As we reported in an earlier blog post:
“The following often apply to those who decide to become money lenders:
We then noted: "It's really not that hard getting your name out as a private lender. It's as easy as registering an account with any of the crowdfunding platforms." Some of the larger ones specializing on the debit side are listed by LoansMarket.
These lending platforms were initially intended to be entirely peer-to-peer, but banks and non-bank financial institutions crowded out most individual investors years ago. That said, there are still many holdouts, especially in the mortgage niche. We have reported that individuals who do not meet the above criteria still play in this field.
“It used to be that individual lenders were millionaires who could afford to loan cash and handle the risk of not being paid back,” we quoted AnnaMaria Andriotis as writing for MarketWatch. “Now middle-income pre-retirees, ranging from chiropractors to professors, are joining their ranks.”
We then added that “these middle-class lenders tend to be less sophisticated investors. They generally don't have hundreds of thousands of dollars. They can’t shrug it off if it doesn't get paid back.”
According to McKinsey, private lending funds raised $124 billion in 2020. The growth was fueled by bank disintermediation borne of deregulation and low-interest rates.
We considered calling this category "physical" or "tangible" assets. "Utile" was the word we settled on because, although some of these are neither physical nor tangible, we can use them for something besides financial investment or speculation.
While we discussed precious metal futures as financial assets, people still want gold or silver bars in their possession. According to the Perth Mint, Australia's official gold bullion source, 47% of the gold in human possession is worn as jewelry. Also, 17% is held as reserves by central banks. Another 14% is pressed into industrial use. The remaining 22% is in bar or coin form and held in the hands of private investors or gold-backed ETFs. In other words, far more of the world's investment-grade gold belongs to individuals than to governments.
Of the $9.6 trillion value, the Perth Mint estimates for all the gold in the world, almost $2.0 trillion is held privately by intentional investors. They buy it from many sources, including Perth Mint or through private dealers like APMEX. But then again, some people just buy it on eBay.
As with precious metals, there is a difference between owning livestock as a financial asset and as a physical one, although both are possible.
Racehorses, for example, are relatively popular alternative investments. According to TheStreet.com, as little as $500 can buy fractional ownership -- essentially a share of equine stock. First-time investors often enter the market via auctions known as “breeze-up sales” announced in such outlets as the BloodHorse magazine calendar. With the U.S. industry concentrated around Lexington, Ky., it is a global business, although at least one company, Fasig-Tipton, holds breeze-ups throughout the U.S.
Other livestock can also be bought at an auction, as Howcast’s video explains. Cattle USA offers a calendar of events. In addition to cattle, though, poultry is also sold on the block. While one might expect both layers and broilers to be on offer, a CNN Money article also notes that money can be made from selling chicken feces to fertilizer producers. The article further describes how ostriches and dressage horses -- dressage, an Olympic sport, is essentially ballet on horseshoes -- are available as investments. Other sources list more mundane assets as lambs and goats and such quirks as rabbits and bees.
Any object that even one person fetishizes can be a collectible. The greater the number of people who share the passion, the more liquid the market for those assets. According to MoneyCrashers, the most lucrative include:
Firearms are also a notable segment, according to the CNN article.
And yet, this barely scrapes the surface. Sources such as TheStreet.com and Investopedia list childhood toys, pop memorabilia, sports memorabilia, mid-20th century furniture, vintage fashion, and vintage computers as growing markets. Rare trading cards -- both sports-themed and for such strategy games as Pokémon -- are also sought-after artifacts, as are comic books. According to hobbyDB, more than $200 billion per year is spent on collectibles, not including classic cars. hobbyDB also reports a $15 billion per year market in militaria; according to ArtNet, a disturbingly high proportion of this market is focused on Nazi memorabilia.
Of course, few want to be known as Waffen SS enthusiasts, but there are more benign reasons for not wanting to be acknowledged as the owner of a particular artwork or gem. Private collectors are just that -- private. So it is a broadly appealing feature of the collectibles market that most of its transactions can be conducted anonymously, either through private sales or auctions. The largest auction houses for collectibles are Sotheby’s and Christie’s. There are also specialized houses for coins, jewelry and gems, stamps, and most other categories.
Christie's, though, broke new ground with its recent $69.3 million sale of The First 5,000 Days, a virtual mosaic of digital images by the artist known as Beeple. The work is not a physical object but rather an NFT which, as discussed previously, is a unique blockchain instance. The anonymous buyer purchased an easily copied-and-pasted array of pixels, but with a set of identifiers embedded in the code proving that he is the true owner. NFTs have a moment as collectibles now, but it remains to be seen if the momentum continues. OpenSea is the leading marketplace for NFTs.
To restate, the universe of potential alternative investments is limitless. That said, we would be remiss not to at least mention:
By far, the most popular alternative investment, though, is real estate. While owning one's own home is a cornerstone of "the American dream" -- whether or not it makes financial sense in a particular case -- a well-diversified portfolio would almost always include some investment in commercial real estate.
CRE is a broad category that includes everything from shopping malls to office buildings to apartment complexes. It includes hotels, assisted living communities, warehouses, and the surprisingly fast-growing self-storage market. Investors can fund development projects, which involve construction on greenfield land or renovating older buildings. They can also invest in management companies that serve the traditional landlord functions of maintaining the physical plant and collecting rents.
These opportunities usually take the form of limited liability corporations, with the investors serving as passive participants. The National Association of Real Estate Investment Trusts estimates the value of CRE in the U.S. at $16 trillion. Investopedia offers a list of real estate crowdfunding sites, which tend to provide low buy-in barriers.
As expansive as CRE is, it is not all there is to the market.
First of all, there is opportunity in residential real estate -- buildings with living space for between one and four households. In much the same way people might buy their own house, they can buy another and rent it out. If they are handy and are good project managers, they can participate in the "fix-and-flip" market -- buying substandard homes, improving them, and reselling them at a much higher price.
Farms represent another set of opportunities. Few people involved in alternative investments want to work the farm, but it could be a lucrative hobby with the right tenants in place to do so. While one generally thinks of dairy or poultry or grain farms, the CNN article notes how investors have succeeded in raising habañero peppers, organic sprouts, or Christmas trees.
In some sections of the U.S., particularly out West, water and mineral rights trade separately from the existing topsoil and buildings. Like collectibles, they trade at an auction or via private sale. Both private auction houses and state governments conduct auctions.
Tax lien certificates are perhaps the most overlooked corner of the real estate market. These liens are claims the municipal government has on properties in tax arrears and are then auctioned off to investors. While not every city and town issues such certificates, the National Tax Lien Association knows of around 2,500 that do, so it would not be difficult to find a tax jurisdiction nearby. They are advertised via public notice in local newspapers. The investor acts essentially as a collection agent and, if the homeowner does not pay off the lien, the investor could then own the property. It is hardly a sure thing, though, as there is a litany of risks involved.
Almost none of the aforementioned asset types, as of this writing, are permitted in any 401(k) account or most other qualified plans, including most individual retirement accounts. The one exception is the self-directed IRA, as we have covered previously.
And yet, for all the risk these alternative investments pose in isolation, they might be spectacularly accretive as elements in a diverse, well-balanced portfolio.
Anyone can invest in collectibles. Commodity futures and cryptocurrencies have become mainstream. Residential real estate is practically an American birthright. Beyond that, much of what has been discussed requires a degree of sophistication that the typical retail investor lacks. Those who do not reach the threshold of accredited investors might not be entitled to participate in many vehicles. Even those that do permit non-accredited investors present risks that might not be appropriate.
Stay up-to-date with the latest articles, tips, and insights from the AET team