Expand your investment universe beyond traditional stocks and bonds by adding alternative investments such as hedge funds, private equity, real estate or tangible assets. 

These non-traditional asset classes can improve your portfolio’s risk-return profile by reducing correlation to market movements. Alternative investments are speculative and involve a high degree of risk. These strategies may also be illiquid.

Hedge Funds

Hedge funds can be an important part of a well-diversified portfolio, adding diversification from an equity and interest rate perspective while offering a potentially higher return. But it’s essential to understand how hedge funds operate and perform due diligence before investing in one.

A hedge fund is an investment vehicle that uses a variety of strategies to improve the risk-reward ratio of its investments. These include leveraged investing (buying more than you can afford to sell), short selling (borrowing a security, then buying it back at a lower price to profit from a decline in its value) and using derivatives to reduce the risk of exposure to market movements.

Hedge funds may invest in a wide range of assets, including debt and equity securities, commodities, currencies, and derivatives. Some have broad investment mandates, while others are more focused on specific macroeconomic factors.

For example, some managers use fixed income arbitrage strategies to exploit pricing inefficiencies between related fixed income securities. Equity market neutral strategies seek to limit volatility compared to a competitive stock index. And convertible arbitrage funds profit from temporary pricing discrepancies between convertible bonds and their underlying stocks.

These and other strategies can increase your portfolio’s ability to withstand market downturns, but they can also decrease its gains in rising markets. Before investing in a hedge fund, make sure the risks are appropriate for your personal investing goals, time horizon and appetite for risk.

Private Equity

Investing in private equity offers opportunities to take part in the growth of private companies, a class that includes buyouts and late-stage venture capital. These companies face fewer regulatory hurdles than publicly traded firms and are thus able to grow more rapidly.

Private equity firms often rely on economies of scale by acquiring similar assets (e.g. apartments or fishing vessels) in order to generate higher returns from efficiencies like shared staffing and maintenance. However, this approach is not without cost, as it can shift the burdens of running a company onto workers: whether that’s nurses who have to make do with fewer supplies, apartment tenants who pay more for amenities, or fishermen whose earnings are reduced by the higher operating costs shifted to them.

Alternative investments have the potential to complement traditional equities and fixed income positions in a portfolio. They can also offer diversification benefits that reduce market risk and improve portfolio return potential.

However, a number of factors distinguish alternative strategies from their traditional counterparts: they are typically more active and often employ leverage, which may result in volatile investment performance. They also tend to have lower liquidity and less regulatory oversight than traditional investments, while they often have more complex legal and tax considerations. Lastly, they are generally more expensive and can have difficulty measuring performance on a before-fee basis given their often illiquid nature and redemption restrictions.

Real Estate

Incorporating alternative investments into portfolios may be beneficial for investors seeking to guard against the volatility of equities, hedge against inflation and/or generate higher returns than traditional listed stocks or bonds. The investment categories outlined above, including hedge funds, private equity, real estate, and impact investing, each boast unique advantages that can add value to investors’ portfolios.

However, it’s important to understand the nuances between these strategies. Because these investments are typically less liquid, they may require larger initial minimums and have higher fees versus retail-oriented mutual funds and exchange-traded funds (ETFs). Additionally, it can be difficult to find verifiable market data for many of them, as they may not be publicly traded.

Nonetheless, there are several ways to gain access to these investments. Investors can pursue direct investments by acquiring ownership in a private vehicle structure, such as a limited partnership, or through funds that seek to acquire these assets on behalf of investors. In either case, performing thorough due diligence prior to any investment is paramount to ensure operational, financial and counterparty risks are being analyzed.

Investing in high-risk opportunities can provide significant returns, but only if you are comfortable with the potential for near-term losses and are willing to make the right buying decisions. In this volatile and uncertain environment, adding alternative investments to your investing playbook may help diversify your portfolio away from the more traditional equities and bonds that are often weighted in most portfolios.

Collectibles

Alternative investments can provide unique opportunities and potentially improve investment outcomes when incorporated into multi-asset class portfolios. However, because they are often less liquid than traditional investments and may use complex financial instruments that can be difficult to understand, alternative investing requires careful research and due diligence.

The return and risk profile of alternative investments varies by strategy, structure, and investment vehicle. Additionally, because many alternative investment strategies are not publicly traded, it can be difficult to obtain historical market data on the performance of these investments. This can increase the potential for making uninformed or inappropriate investment decisions. Moreover, some alternative investment vehicles may be more susceptible to fraud and misconduct than their public counterparts and are typically subject to lower levels of regulatory oversight.

Finally, because many alternative investment strategies utilize complex financial instruments and hedging techniques that can significantly increase their risks, they can be subject to higher volatility and may not perform as advertised. Further, many alternative investments are not suited for retail investors and are typically available to accredited investors only.

As such, investors should consider carefully their investment objectives, risk tolerance, and time horizon before investing in any alternative investment strategy. Investing in collectibles, for example, can be an exciting and potentially profitable way to diversify one’s portfolio. However, collectors should understand that their returns will be far below the returns of a stock market index fund or a money market account and should carefully weigh the potential benefits of this type of investment against its risks.