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A Guide to Alternative Investments

The rapid rise of bitcoin captured investors’ imaginations last year. The cryptocurrency was trading below $1,000 on January 1, doubled in a matter of months and eventually peaked at $19,783 on December 17.

You may know—or easily guess—what came next: Bitcoin beat a retreat as regulators zeroed in, plunging about 65% by early February 2018.

Cryptocurrencies may yet reshape the financial world, but as the above trajectory suggests, those tempted to follow suit after watching fast fortunes being made should invest only as much as they can afford to lose.

More traditional alternative investments, however, may well have a place in your portfolio. Commodities can help protect against inflation; real estate investment trusts (REITs) can provide reliable income; liquid alternatives can help manage market and downside risk. And all three are substantially cheaper than competing hedge and private-equity funds, with their high investment minimums and extended investment time horizons.

“Not all alternative investments are appropriate for every investor,” says Randy Frederick, vice president of trading and derivatives at the Schwab Center for Financial Research. “But when they’re aligned with an investor’s goals and risk tolerance, they can often provide real benefits.”

To figure out whether a particular investment is right for you, it helps to ask a few questions:

  • How much time and effort can you afford to put in? It takes work to fully comprehend the potential risks and rewards of many alternative investments.
  • How much are you willing to pay? Some alternatives can be expensive, with high fund fees and other costs that can eat away at returns.
  • How soon do you need your money back? Alternative investments may be less liquid than bonds and stocks, so you might not get the best price if you suddenly need to sell.
     

“Some investors wait until they lose money or are unexpectedly locked in before giving an investment a proper look,” Randy says. “Obviously, it’s better to do your research up front.”

The bigger question, says Anthony Davidow, asset allocation strategist at the Schwab Center for Financial Research, is: What does the underlying investment do for you? “The sooner you can zero in on what you’re trying to achieve—whether that’s seeking excess returns or reducing the risk in your portfolio—the better the potential outcome.”

With that in mind, here are three fairly common alternative investments—and two more out-there options—worth considering.

Commodity funds

Investing in commodity funds can provide a hedge against inflation when the economy is booming. Precious metals, and gold in particular, are seen as safe-haven investments because they tend to rise in value when other markets are in turmoil. That doesn’t mean they’re especially stable—in fact, they’re often pretty volatile—but they do tend to behave differently from other investment classes.

Of course, almost any commodity can be held through a mutual fund or an exchange-traded fund (ETF)—but make certain you understand the underlying mix, which can vary significantly by index. According to fund prospectuses, crude oil accounts for 45.6% of the iShares S&P GSCI Commodity-Indexed Trust,1 for example, whereas the Invesco DB Commodity Index Tracking Fund holds about half as much crude oil but twice as much gold.2

To search for commodity funds for your portfolio, log in to the fund screener tool, select Alternative under Fund Category and then choose Commodities Broad Basket under Morningstar Category.

Liquid alternatives

These hybrid investment vehicles mimic specific hedge-fund strategies but are structured like mutual funds. And although liquid alternatives don’t adhere to the “2-and-20” fee structure common to hedge funds (2% of assets annually plus 20% of any gains), they are often more expensive than many actively managed mutual funds and much more expensive than your typical index fund.

Liquid alternatives command higher fees in part because of their ability to go long and short on their investments, which can help investors manage volatility and downside risk. In fact, studies have shown that their performance can be comparable to their much more expensive hedge-fund counterparts.3

Be that as it may, it’s important to find a liquid-alternative fund that aligns with your goals. Many are defensively positioned, so they may underperform during rising markets.

To search for liquid-alternative funds for your portfolio, log in to the fund screener tool, select Alternative under Fund Category and then choose any of the categories under Morningstar Category except Commodities Broad Basket.

REITs

Real estate investment trusts—which own real estate–related products and are generally traded on public exchanges—are another alternative investment you’re likely to hear about from an investment advisor or wealth strategist. That’s because REITs provide the potential for both growth and income due to their unique structure.

Although their income can be greater than that from bonds and stocks, REITs may also be more volatile—and the bulk of their payouts are taxed as ordinary income, so consider holding them in a tax-deferred portfolio whenever possible.

To search for REITs for your portfolio, log in to the fund screener tool, select Sector under Fund Category and then choose Real Estate under Morningstar Category.

Investors who meet certain requirements4 may have access to a broader array of alternative investments through hedge funds and private-equity funds. (Hedge funds tend to invest in more-liquid—often publicly traded—securities, whereas private-equity funds make longer-term investments, often in individual companies.) That said, those interested in hedge funds or private equity might first consider liquid alternatives (see above), which are less expensive and offer exposure to many of the same strategies.

Hedge funds

These funds—which pool capital from accredited investors or institutional investors—are best known for their complex (and often risky) investment strategies. Although their strategies vary, hedge funds have one thing in common: Performance rarely correlates with more-traditional investment vehicles, such as stocks, bonds, mutual funds and ETFs. Indeed, an analysis by the Schwab Center for Financial Research found that, over a 10-year period, many popular hedge-fund styles provided more diversification from the S&P 500 Index than, say, international equities did. However, hedge funds remain inordinately expensive, with many charging 2% of assets annually plus 20% of any gains.

Private equity

Once upon a time, investors in search of the higher potential returns offered by private-equity funds had to commit their money to the fund for an extended period, sometimes as long as a decade. Today, some private-equity investments are available in nontraded registered funds, which can be liquidated once per quarter.

But this apparent advantage might in fact be a disadvantage. After all, putting your money to work over a longer period is often key to the potential outperformance of private-equity funds, which frequently purchase struggling companies and need time to turn them around. “If you don’t have the stomach for locking up your money for an extended period of time,” Tony says, “private equity may not be right for you.”

If you remain interested in hedge or private-equity equity—despite the aforementioned caveats—talk to your Schwab financial consultant. He or she may be able to provide a referral to a registered investment advisor who can help.

Finding your mix

Of all the alternative investments mentioned, commodities and REITs may be the most deserving of a place in investors’ portfolios—based not only on their own merits but also on the diversity they can provide.

“Both asset classes, when introduced in relatively limited quantities, have historically helped reduce volatility without significantly affecting returns,” Tony says. “However, a little exposure goes a long way. Most investors should limit their entire alternative-investment allocation to no more than 5% of their portfolio.”

1As of 04/27/2018.

2As of 12/31/2017.

3Performance of Private Versus Liquid Alternatives: How Big a Difference? Cliffwater, 06/19/2013.

4Defined by the Securities and Exchange Commission as anyone with earned income of more than $200,000 ($300,000 if married and filing jointly) in each of the prior two years—and who reasonably expects to maintain that level of income for the current year—or has a net worth of more than $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence).

What You Can Do Next

Schwab clients can use the mutual fund and ETF screeners to search for alternative-investment funds for their portfolios.

How to Combat Volatility, Inflation and Rising Rates
Taking the Long View

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Alternative investments, including funds that invest in alternative investments, are risky and may not be suitable for all investors. Alternative investments often employ leveraging and other speculative practices that increase an investor’s risk of loss to include complete loss of investment, often charge high fees, and can be highly illiquid and volatile. Alternative investments may lack diversification, involve complex tax structures and have delays in reporting important tax information. Registered and unregistered alternative investments are not subject to the same regulatory requirements as mutual funds. Investors should obtain and carefully read the related prospectus or offering memorandum, which will contain the information needed to help evaluate the potential investment and provide important disclosures regarding risks, fees and expenses.

Commodity‐related products carry a high level of risk and are not suitable for all investors. Commodity‐related products may be extremely volatile, illiquid and can be significantly affected by underlying commodity prices, world events, import controls, worldwide competition, government regulations, and economic conditions, regardless of the length of time shares are held. Investments in commodity‐related products may subject the fund to significantly greater volatility than investments in traditional securities and involve substantial risks, including risk of loss of a significant portion of their principal value.

Risks of REITs are similar to those associated with direct ownership of real estate, such as changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and credit worthiness of the issuer and may be illiquid.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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