Let's have a look at some of the key features of the main alternative asset classes.
Real estate investing involves investing in a real estate asset directly or through a fund, often referred to as REITs or real estate investment trust. There are a wide variety of types of real estate that can be invested in including residential properties, hotels, and warehouses. Returns are generated in the form of a relatively stable rental cash flow, similar to fixed income and the possibility of significant capital appreciation similar to equities. As a result, real estate is sometimes described as being between equities and fixed income in terms of both risk and return. Direct real estate investing is very illiquid and it can take months or even years to find a buyer for a property. However, investing in REITs offers much more liquidity. Similar to that of listed equities.
There are many different types of commodities which can form part of an investment portfolio. Commodities are raw materials or primary agricultural products and are often subdivided into metals, including precious metals such as gold and non precious metals like tin. Agricultural, including corn, lumber, coffee, or even frozen orange juice and energy, such as oil and natural gas. Unlike many other asset classes, commodity investing only provides returns to investors through capital appreciation. No income is typically earned on commodities. Commodities are often considered to be useful within investment portfolios as they have low correlations with other asset classes and they offer a good inflation hedge. Investing in commodities is typically done using derivatives rather than direct investing.
Private equity investing is often done through funds which typically acquire entire companies. The acquisition is typically finance with high levels of debt, with a view to driving operational improvements and repaying some of the debt with the cash flows of the company. Returns for investors are driven by potential gains on the disposal of the acquired company after three to five years. Private equity investing is highly illiquid since selling the underlying investment, companies can take a very long time. Finally, since private companies are not listed on an exchange, there is less publicly available information compared to publicly listed companies that are Required to disclose more information about themselves to the market.
Infrastructure investing involves either providing the financing for new infrastructure assets or investing in existing assets such as roads, wind farms, or energy transition projects. This is typically done through investing in infrastructure funds, which have the aim of providing long-term stable returns with relatively low risk using the cash generation from the operation of the assets once constructed. There is also the potential for a subsequent sale of an asset to generate capital gains. Infrastructure assets offer a potential inflation hedge to a portfolio as revenues earned from the operation of infrastructure. Assets are often contractually adjusted for inflation.
Hedge funds can take more risk than traditional mutual funds through using leverage and short selling, and since they often have complex investment strategies, they're sometimes suggested as a possible alternative asset class. However, there is significant variation between the wide range of different types of hedge funds. For example, an equity market neutral fund will hold very different assets and have a very different risk return profile from a convertible debt arbitrage fund or a global macro fund. This means that different hedge funds react very differently from each other to economic and market events suggesting they're not a good definition of an asset class. For institutional investors, such as pension plans and endowments, any hedge fund allocation may well be included within the allocation to another asset class. For example, if a fund has a 50% allocation to equities, there might be a maximum allocation of, let's say 10% for investments into equity focused hedge funds.
