To understand what an alternative investment fund is, one must first understand what constitutes a conventional investment fund. An investment fund is a supply of capital pooled by several investors to purchase a basket of securities, of which each investor retains control and ownership of their own shares.
Securities are selected by investment fund managers for their projected growth potential according to technical and fundamental analysis. In other words, each investment is carefully evaluated for its potential to generate capital appreciation.
Interested in getting started with alternative investment funds? In this article, we’ll answer the question, “what is an alternative investment fund?” Read on to find out whether alternative investing is right you and, if so, which type of alternative fund fits with your investment strategy.
Alternative Investing 101
Unlike conventional investment funds, alternatives investment funds invest in asset classes that are not stocks, government bonds, or cash. Alternative investments include hedge funds, private equity, real estate, and other real assets such as precious metals, fine art and commodities.
Beyond the standard alternatives investment classes, there’s a long list of financial instruments and assets that fall under the “alternative investment” category. These include:
- Exchange funds
- Financial derivatives
- Carbon credits
- Distressed securities
- Venture capital
In short, alternative investing provides a wider range of assets for the investor to put their money into. Alternative investments help investors and money managers generate greater returns and meet diversification targets for their clients, but can suffer from the traditional pitfalls of high-risk/high-return investment strategies.
Alternative Investment Funds
Alternative funds are sought after by portfolio managers for their distinct growth trajectory. Funds that invest in non-conventional assets tend to perform in a way that shares little correlation with mainstream market indices such as the Dow Jones or the S&P 500.
It’s no wonder, then, why the alternatives market has enjoyed relative success since the late-2000s financial crisis. Growth models at Booz & Company predict that the alternative investment market will exceed $18 trillion USD globally by the end of the decade.
When chosen wisely, alternative funds can successfully diversify a portfolio by building out into a wider range of assets, capitalization, categories, and industrial sectors. By providing a wider assortment of assets to invest in, alternatives can provide an avenue for portfolio growth that is independent of stock and bond market performance.
Largest Alternative Funds by Net Assets
There are several criteria by which alternative funds are evaluated. However, net assets under management (in USD millions) and 1-year return metrics are two key indicators of success. Below, we’ve listed the top five funds according to these two metrics.
- Vanguard Real Estate Index Fund: $70,500M, 13.50%
- DFA Real Estate Securities Portfolio: $10,600M, 15.14%
- DFA Global Real Estate Securities Portfolio: $9,260M, 13.05%
- Fidelity Series Commodity Strategy Fund: $7,860M, -5.19%
- Cohen & Steers Real Estate Securities Fund: $6,825M, 28.39%
The funds listed above deviate from their conventional counterparts because they avoid long-only strategies in stocks and government bonds. Instead, they combine a variety of short and long strategies in assets such as commodities, ForEx, and real estate, to name a few.
What To Know Before You Get Started
Alternative investing is not without its share of risks and peculiarities. Below, we’ve listed some of the main factors to consider before you add alternative funds to your portfolio.
Most alternative funds are actively managed by fund managers rather than automated AIs or algorithms. Before investing in a fund, do your due diligence and research who is managing the fund and what their credentials are. Unless they have a proven track record of investing success, consider looking elsewhere.
Meet the Minimum
Alternative investment funds often have steeper minimums than standard ETFs. It’s not uncommon to run into funds with a five-figure initial investment minimum. For this reason, alternative investing is usually reserved for cash-rich and high-net-worth investors.
Since alternative funds are managed actively, their expenses tend to skew higher than your standard mutual fund. Don’t be surprised to find expense ratios well in excess of 1.5 percent due to their higher turnover rates and required human inputs.
Alternative funds are less predictable and therefore have a higher degree of market risk than non-traditional investing. The value of commodities, real estate, and currencies tend to fluctuate more than traditional assets like bonds and stocks.
To know what you’re buying into, you need to know the performance history of the fund. Search for funds who have publicly released their five and ten-year yields—newer funds without published historical performance records, or highly variable year-to-year returns, should be treated with skepticism.
The Illiquidity Problem
Non-traditional financial assets such as real estate, art, and commodities are highly illiquid compared to stocks and bonds.
Fortunately, there’s a solution. Some alternative investments are sought after for their higher-than-average liquidity. Affectionately called “alts,” these assets provide daily liquidity for investors. These include short-long equity funds and multi-strategy tactical trading.
Since liquid alternatives tend to be event-driven and require a more active management approach, these funds generally charge higher fees and have higher expense ratios. Despite this, the liquid alternatives market has grown dramatically in recent years, skyrocketing from just over $100 billion in assets under management in 2010 to over $300 billion over the next five years.
The Bottom Line
While the rewards can be enticing, alternative investing isn’t for everyone. Many hedge fund strategies and private capital funds aren’t subject to the same regulatory environment that mainstream investment funds are. Laxer regulations often result in a higher degree of speculation-based trading and leveraging—all of which contribute to the risk of principal loss.
However, don’t let this discourage you from investing in alternatives. In this article, we answered the question “what is an alternative investment fund,” and provided an overview of the many rewards and benefits inherent to alternatives, such as higher returns, lower volatility, and true diversification that performs independent of the stock market.