#009 | Asset Classes
An introduction to alternative investments
Hey friends,
There is a universe of asset classes available to individual investors - why should your diversification end at stocks, bonds, and cash?
Alternative investments allow you to spread your capital across various assets that have uncorrelated risk and return profiles. This can lower your risk and potentially increase your returns… a win-win scenario.
Now that we have broken down stocks and bonds in previous issues, today’s newsletter will provide an overview of the most common alternative asset classes that you will come across.
“There is always a bull market somewhere”
—Jim Cramer
Real Estate
When it comes to real estate, there are 2 primary ways that you can invest - directly or through REITs.
Direct Real Estate
Direct real estate investment involves acquiring and managing physical properties for the purpose of generating income or realizing capital appreciation.
Investors can choose between residential or commercial real estate.
The primary benefits of direct real estate investing include:
Tax advantages: Investors can deduct depreciation, mortgage interest, and other business expenses from their taxable income every year. Additionally, you may be able to defer capital gains earned on an investment property by using a 1031 exchange
Access to leverage: If you qualify for a mortgage, you can get a property for as low as 3.5% down. Debt financing also allows you to amplify your return potential
Hedge against inflation: Real estate has historically been a solid hedge against inflation, allowing your capital to maintain its purchasing power
While the benefits of real estate investment can paint a rosy picture, there are also significant risks that should be considered:
Liquidity: Real estate is generally less liquid than stocks and bonds, meaning they aren’t as easy to quickly convert to cash
Property management responsibilities: Property management can be time-consuming and may require dealing with tenants, maintenance, and other operational aspects of a business
Access to leverage: While debt financing can amplify returns, it also magnifies the risk associated with your investment. If your tenants stop paying rent, you’re still responsible for paying the mortgage. Rising interest rates also affect the affordability of debt and your return on investment
Real Estate Investment Trusts (REITs)
REITs are a popular and accessible way for investors to gain exposure to real estate without managing physical properties.
There are 3 primary categories of REITs:
Equity REITs: Own and operate income-producing real estate. They generate revenue from rent and, in some cases, capital gains from property sales
Mortgage REITs: Invest in real estate mortgages and mortgage-backed securities. They earn income through the interest on these loans and can be more sensitive to interest rate changes
Hybrid REITs: Combine the features of equity and mortgage REITs. They invest in both physical properties and mortgages
REITs are bought and sold like stocks, which offers investors greater liquidity and flexibility.
Commodities
Commodities are tangible, raw materials, such as precious metals (gold, silver, palladium), energy resources (oil and natural gas), agricultural products (corn and soybeans), industrial metals (like copper), and more.
Commodities offer a unique outlet for diversification, as their values aren’t driven by traditional market trends. Commodity prices are more influenced by global economic factors and supply-demand dynamics.
Price appreciation can occur as a result of global demand, geopolitical events, and supply constraints.
Commodities are inherently volatile though. Prices can quickly collapse due to factors like weather conditions and geopolitical tensions.
Private Equity
Private Equity is a blanket term for businesses that aren’t publicly traded.
You can directly invest in private businesses when you have a relationship with a business owner or broker, but they can also be accessed through private equity funds, venture capital funds, and equity crowdfunding platforms.
This asset class allows investors to participate in the early-stage growth of companies before they go public or experience substantial expansion.
Private equity returns often exceed the returns earned in public markets. Research from Cambridge Associates states that private equity has outperformed stocks for the last 25 years (as of 12/31/22).
While private equity investments come with the prospect of higher rewards, they also involve higher levels of risk and illiquidity.
Investors should be prepared for longer holding periods and carefully assess the fund manager's track record, expertise, and investment strategy before committing capital to a private equity fund.
Hedge Funds
Hedge funds are investment vehicles that pool capital from accredited investors, institutions, or both.
They employ diverse strategies in public markets, including long/short equity, global macro, event-driven, arbitrage, and more. They may also use leverage and derivatives to accomplish their investment goals.
These unorthodox strategies enable hedge fund managers to capitalize on market inefficiencies, mispricings, and other unique opportunities. They aim to deliver alpha, or active returns, to investors regardless of market conditions.
Investors interested in hedge funds should carefully evaluate the fund's strategy, track record, fees, and risk management practices.
Cryptocurrency
Cryptos represent a form of digital currency that is built on blockchain technology.
The most well-known cryptocurrency is Bitcoin, but there are thousands of other altcoins, each with its own unique features and purposes. Popular altcoin networks include Ethereum, Cardano, Solana, and Ripple.
Cryptocurrencies are decentralized, which means they operate independently of a central authority, such as a government or financial institution.
Investors buy cryptocurrencies with the expectation of capital appreciation, staking rewards, or some mix of both.
While crypto investors are attracted to the idea of high return potential, digital assets have been significantly volatile over the past decade. It's essential to recognize the speculative nature of the market and its associated risks.
Derivatives
Derivatives are financial instruments whose value is derived from the price of an underlying asset, index, or rate.
They serve as contracts between two parties, where the terms specify the future exchange of assets, cash flows, or other financial instruments. These instruments enable investors to hedge against risks or speculate on future price movements.
Common types of derivatives include futures contracts, options, and swaps.
Futures contracts obligate the buyer to purchase, or the seller to sell, an asset at a predetermined price on a specified future date.
Options provide the holder with the right (but not the obligation) to buy or sell an asset at a predetermined price within a specified timeframe.
Swaps involve the exchange of cash flows between two parties, helping manage risks related to interest rates, currencies, or commodities.
Derivatives are complex securities that can be extremely volatile, so they should be limited to sophisticated investors with careful risk management strategies.
Conclusion
Investors who want to build a well-balanced portfolio should have a comprehensive understanding of the various asset classes.
By adding alternative investments to their portfolio, investors can mitigate risks and potentially enhance their return potential.
“Diversification is the only free lunch in investing”
—Henry Markowitz
That’s all for today - thank you for taking the time to read!
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