What Counts as an Alternative Investment?
ALTERNATIVES
“Anything can be an investment if it produces income.” — Howard Marks
What Counts as an Alternative Investment?
The traditional foundation of modern portfolio construction has long rested on two pillars: publicly traded equities and fixed income. For decades, the "60/40" portfolio—comprising 60% stocks for growth and 40% bonds for income and stability—was the standard for institutional and retail investors alike.
However, as markets evolve and correlations between stocks and bonds occasionally tighten, investors increasingly look toward "alternative investments" to provide something the public markets may lack.
To evaluate these options rationally, one must first define what they are. In the broadest sense, an alternative investment is any financial asset that does not fall into the conventional categories of public stocks, bonds, or cash.
Yet, this definition is too broad to be useful for a disciplined investor. To understand the role of these assets, we must look past the label and examine their underlying mechanics.
Should you diversify with alternative investments?
The Functional Taxonomy
Alternative investments are not a monolithic group. They represent a wide array of strategies and assets that behave differently under various economic conditions. They can generally be grouped into four primary categories.
1. Private Capital
This category involves investing in the equity or debt of companies that are not listed on public exchanges.
Private Equity (PE): Investors buy stakes in private companies, often with the intent of restructuring operations or accelerating growth before selling the company or taking it public.
Venture Capital (VC): A subset of private equity focused on early-stage startups with high growth potential but significant failure rates.
Private Credit: This involves lending directly to companies. As traditional banks have faced stricter regulatory lending requirements, private lenders have stepped in to provide corporate debt, often at higher interest rates than public bond markets.
2. Real Assets
Real assets are physical assets that have intrinsic value due to their substance and properties.
Real Estate: This includes commercial properties (offices, retail, industrial) and residential portfolios. While some investors access this via public REITs, "alternative" real estate typically refers to private equity real estate funds.
Infrastructure: Investments in essential services such as toll roads, bridges, pipelines, and renewable energy grids. These often provide long-term, inflation-linked cash flows.
Farmland and Timberland: These assets provide a hedge against inflation and are driven by biological growth and global commodity demand rather than economic cycles.
3. Hedge Funds
Unlike private equity or real estate, hedge funds are defined more by their strategy than the underlying assets. They often trade public stocks and bonds but use "alternative" techniques such as short-selling, leverage, and derivatives.
Strategies like Managed Futures or Global Macro seek to profit from market trends or economic shifts, regardless of whether the broader stock market is rising or falling.
4. Collectibles and Non-Productive Assets
This is the "fringe" of the alternative world. It includes art, vintage cars, wine, and more recently, digital assets like cryptocurrency.
From an analytical perspective, these differ from the first three categories because they are generally non-productive. They do not produce cash flow, dividends, or interest. Their value is determined solely by the "greater fool theory" or changes in subjective demand.
Why Asset Allocation Matters More Than Asset Selection
The Three Pillars of "Alternativeness"
To distinguish a true alternative from a traditional investment, we must look at three structural characteristics: liquidity, valuation, and access.
1. The Liquidity Profile
Public stocks can be sold in seconds. Many alternative investments require "lock-up periods" where your capital is committed for five to ten years.
This illiquidity is often cited as a feature, not a bug. It prevents panic selling during market volatility and allows fund managers to execute long-term turnarounds. In exchange for this lack of access, investors expect an "illiquidity premium"—a higher return than what is available in public markets.
2. Valuation Frequency
Public markets provide "price discovery" every second the exchange is open. Alternatives do not. A private equity fund or a piece of real estate is valued periodically, often quarterly, based on appraisals.
This creates an "averaging" effect. Because the prices do not fluctuate daily, the volatility of alternatives often appears lower than that of public stocks. Investors should be wary of this: "smoothed" volatility is not the same as a lack of risk. It is simply a lack of data points.
3. Access and Structure
Most institutional alternatives are structured as Limited Partnerships (LPs). The investor is a "Limited Partner," and the fund manager is the "General Partner" (GP).
This structure involves "capital calls," where the investor commits a certain amount of money but only provides it when the manager finds a suitable investment. This makes cash flow management more complex for the individual investor.
The Marketing Trap: Speculation vs. Strategy
The term "alternative" has become a powerful marketing tool. Because institutional investors (like pension funds and endowments) use alternatives, the label is often applied to speculative products to give them an air of sophistication.
A disciplined investor must distinguish between an alternative asset and an alternative gamble.
A private credit fund that lends to mid-sized manufacturing companies is an alternative strategy based on cash flow and credit risk. A collection of digital tokens or rare baseball cards is a speculative play based on sentiment.
While both are "alternatives" to stocks and bonds, they serve entirely different purposes in a portfolio. One is a structural diversifier; the other is a concentrated bet on price appreciation.
[Internal link: Understanding the Illiquidity Premium]
The Cost of Complexity
Complexity is rarely free. Alternative investments carry burdens that traditional index funds do not.
Fees: The "2-and-20" model (a 2% management fee and a 20% performance fee) remains common in the private equity and hedge fund world. These fees significantly raise the "hurdle rate"—the return the investment must achieve before the investor sees a profit.
Tax Complexity: Many alternatives issue K-1 forms instead of standard 1099s. This can delay tax filings and increase the cost of accounting.
Transparency: Unlike a public company that must file audited quarterly reports with the SEC, private funds offer limited transparency. You are often betting on the integrity and skill of the manager rather than the underlying assets themselves.
The Role of Alternatives in a Portfolio
Alternative investments are not a "get-rich-quick" mechanism. In a disciplined portfolio, their role is usually one of the following:
Lowering Correlation: Finding assets that do not move in lockstep with the S&P 500.
Inflation Protection: Utilizing real assets like infrastructure or commodities that tend to hold value when currency devalues.
Enhanced Yield: Using private credit to find higher income than what is available in the liquid bond market.
However, these benefits come at the cost of transparency, liquidity, and higher fees. For many investors, the simplicity and low cost of a traditional stock-and-bond portfolio outweigh the marginal benefits of alternatives.
Grounded Takeaway
An investment is not superior simply because it is "alternative." The label is a description of how the asset is accessed and priced, not a guarantee of its quality.
Before moving beyond public markets, an investor must ask: Am I being compensated for the illiquidity? Do I understand how this asset produces cash flow? Or am I simply attracted to the novelty of something different?
In the pursuit of long-term wealth, discipline and a clear understanding of risk matter far more than the complexity of the assets you own. Alternatives can be a useful tool for diversification, but they are never a substitute for a sound, rules-based investment philosophy.