What Are Alternative Investments?
The Question:
After the 2008 financial crisis, many investors asked: "How can I protect myself when everything falls together?"
The answer often given: alternative investments. Assets that don't move in lockstep with stocks and bonds.
But alternatives come with their own challenges—complexity, illiquidity, high fees, and often disappointing returns. Understanding them is essential before adding them to your portfolio.
Alternative investments are anything outside traditional stocks, bonds, and cash:
- Real estate (beyond your home)
- Commodities (gold, oil, agricultural products)
- Private equity and venture capital
- Hedge funds
- Collectibles (art, wine, cars, watches)
- Cryptocurrency (covered in separate lessons)
Why they're called "alternatives":
- Different return drivers than public markets
- Often less liquid (can't sell easily)
- Potentially lower correlation with stocks/bonds
- Typically more complex
The Appeal of Alternatives
Diversification
The theory: When stocks crash, alternatives might hold value or even increase. True diversification reduces overall portfolio risk.
The reality: In major crises, correlations often increase—everything falls together. Alternatives may diversify in normal times but offer less protection in crashes than expected.
Return Potential
The theory: Alternatives offer access to unique returns not available in public markets. Private equity can outperform stocks.
The reality: After fees, many alternatives underperform simple . The best performers are often inaccessible to regular investors.
Protection
The theory: Real assets (commodities, real estate) protect against inflation.
The reality: Some protection exists, but it's imperfect. TIPS and I-Bonds may offer more reliable inflation protection.
Categories of Alternatives
Real Assets
Things you can touch:
- Real estate investment trusts (REITs)
- Direct real estate investment
- Commodities (gold, silver, oil, agricultural)
- Farmland and timberland
- Infrastructure
Private Capital
Investments in private companies:
- Private equity (buying established private companies)
- Venture capital (investing in startups)
- Private debt/credit
- Growth equity
Hedge Strategies
Complex trading approaches:
- Long/short equity
- Market neutral strategies
- Global macro
- Event-driven strategies
- Managed futures
Collectibles
Tangible items with potential appreciation:
- Art
- Wine
- Classic cars
- Watches
- Sports memorabilia
- Rare coins and stamps
Who Should Consider Alternatives?
Prerequisites
Do This
Before considering alternatives, you should have:
- Maximized tax-advantaged retirement accounts
- 6+ months emergency fund
- No high-interest debt
- Solid understanding of stock/ investing
- Long time horizon (10+ years for most)
- Ability to lose the investment entirely
Typical Investor Profile
Alternatives may be appropriate if you:
- Have significant assets ($500k+ investable)
- Seek diversification beyond stocks/bonds
- Understand and accept illiquidity
- Can handle complexity
- Have access to quality options
Alternatives are probably NOT for you if you:
- Still building basic emergency fund
- Haven't maxed retirement accounts
- Need
- Want simplicity
- Have modest investment amounts
The Problems with Alternatives
High Fees
Alternative investment fees:
| Investment Type | Typical Fees |
|---|---|
| Index funds | 0.03-0.20% |
| Hedge funds | 2% + 20% of profits |
| Private equity | 2% + 20% of profits |
| REITs | 0.5-1.5% |
| Commodities ETFs | 0.4-0.75% |
Fees compound: 2% annually over 20 years costs over 30% of your potential returns.
Illiquidity
Can't sell when you want:
- Private equity: 7-10 year lockups common
- Direct real estate: Months to sell
- Collectibles: Finding buyers takes time
- Even "liquid alts" may gate redemptions in stress
Illiquidity is most painful when you need money most.
Complexity and Opacity
Hard to understand and monitor:
- Complex strategies difficult to evaluate
- Holdings may not be disclosed
- Performance hard to verify
- Tax implications complicated
Access Issues
Best options often restricted:
- Top hedge funds closed to new investors
- Top PE funds require $10M+ minimums
- Best VC requires connections
- What's available to retail may be inferior
Underperformance
After fees, many disappoint:
- Average hedge fund underperforms 60/40 portfolio
- Median PE may not beat public markets after fees
- Commodities have low long-term real returns
- Collectibles are speculative and illiquid
Accessible Alternative Options
REITs (Real Estate Investment Trusts)
What they are:
- Publicly traded companies owning real estate
- Required to distribute 90% of income as dividends
- Easy to buy in brokerage account
- Liquid like stocks
Considerations:
- Already included in total market indexes (~3-4%)
- Tax-inefficient (dividends taxed as ordinary income)
- Correlates with stocks during crises
Commodity ETFs
What they are:
- Funds tracking commodity prices
- Gold ETFs (GLD, IAU)
- Broad commodity funds
- Easy access through brokerages
Considerations:
- Commodities have low long-term real returns
- Contango can hurt performance
- May not provide expected inflation protection
- Small allocation (5-10% max) if at all
Alternative Mutual Funds/ETFs ("Liquid Alts")
What they are:
- Mutual funds using hedge fund strategies
- Daily liquidity
- Lower minimums
- SEC regulated
Considerations:
- Higher fees than index funds
- Performance generally disappointing
- May not provide claimed diversification
- Often complexity without benefit
Crowdfunding Platforms
What they are:
- Real estate crowdfunding (Fundrise, Crowdstreet)
- Startup investing (Republic, Wefunder)
- Art investing (Masterworks)
- Direct investment in alternatives
Considerations:
- Lower minimums than traditional alternatives
- Still illiquid (years to exit)
- Platform and project risk
- Mixed track records
- Relatively new industry
How Much in Alternatives?
Conservative Approach
For most investors: 0-10%
If you include alternatives at all:
- REITs: 5-10% (may already be in total market)
- Commodities: 0-5%
- Other alternatives: Only if truly appropriate
Endowment Model
University endowments (Yale, Harvard) allocate 50%+ to alternatives.
But you're not an endowment:
- They have 30+ year time horizons
- Access to top managers
- Full-time investment staff
- Can handle extreme illiquidity
- Different tax considerations
Copying endowment allocation is usually inappropriate for individuals.
Making the Decision
Questions to Ask
-
What problem am I solving?
- "Diversification" is often available through stocks/bonds
- "Higher returns" is uncertain after fees
-
What's the total cost?
- Include all fees, not just stated
- Consider tax implications
-
Can I access quality options?
- Retail-available alternatives often inferior
- "Democratized access" doesn't mean good access
-
Am I comfortable with illiquidity?
- Can I truly lock up this money for 10 years?
- What if I need it unexpectedly?
-
Do I understand it?
- Can I explain how it works?
- Do I know what could go wrong?
The Simple Alternative
Pro Tip
For most investors, the best "alternative" is:
- Total
- Total bond market index fund
- Maybe TIPS for inflation protection
This gets you:
- Real estate exposure (REITs in index)
- Commodity exposure (through companies)
- Global diversification
- Low costs
- Simplicity
- Liquidity
The Bottom Line
Alternative investments promise diversification and enhanced returns, but reality often disappoints. High fees, illiquidity, complexity, and access issues mean most individuals are better served by simple, low-cost stock and bond index funds. If you do pursue alternatives, ensure you've first built a solid financial foundation, can handle illiquidity, understand what you're buying, and limit allocation to a small portion of your portfolio. The best returns often come from boring, consistent investing—not chasing exotic alternatives.