Best practices for investing in alternatives
If you are like most people who have found their way to our blog, you’re already familiar with traditional assets like stocks, bonds, and mutual funds. But how much do you know about alternative assets?
In today’s post, we dig deeper into what alternative assets are and why you should consider investing in them, as well as offer some alt investing best practices.
Let’s jump in.
What are alternative assets?
The term “alternative assets” refers to any type of investment that (a) falls outside traditional assets such as stocks and bonds, and (b) is not cash. Alternative assets also tend to have a low correlation with traditional assets, are less liquid, and can often be leveraged to provide a steady flow of passive income. Some examples of alternative assets include real estate, franchises, wine, art, hedge funds, collectibles, and private equity.
Why consider alternatives?
Alternative assets come with a unique set of benefits that appeals to many different types of investors.
Diversify your portfolio & mitigate volatility
Alternatives are vital for investors who want to diversify their investments and increase their chances of achieving positive returns. One of the core tenets of a diversification strategy is to reduce exposure to any single type of asset by spreading investments across multiple classes. This way, negative changes in one market or asset type won’t sink the entire portfolio.
Alternative assets have a very low correlation with traditional markets. So, even when stocks and bonds experience dramatic fluctuations, these conditions won’t necessarily carry over into an investor’s alternatives portfolio. The alts markets tend to be high friction and the value of these assets fluctuates minimally from day to day, which provides long-term stability that appeals to many investors.
Create passive income
Alternative assets, such as commodities and real estate, are excellent ways to create streams of passive income. Some investors take this idea one step further and optimize their entire portfolio around generating consistent cash flow. If executed correctly, an income-investing portfolio can effectively supplement a fixed income or simply free up investors’ time to focus on other ventures. And who wouldn’t want a long-term source of income that doesn’t require the time or labor investment of a second career?
Build recession resistance
Alternative assets are a great tool to help investors weather periods of economic recession. Many alts retain their value even in adverse market conditions because of their intrinsic value. These are typically real assets in which investors hold direct ownership and can benefit from long-term equity appreciation. Other alternatives, like certain franchises, fare well during recessions because they’re the source of essential services. Both of these types of alts can function to preserve wealth in the face of economic downturns.
Hedge against inflation
To successfully hedge against inflation, a portfolio should be structured so its rate of return outpaces the rate of inflation. Alternative assets, particularly those that are real, tend to perform well here for the same reasons they effectively resist recessionary conditions. Although their prices in the short term can be hard to predict, real assets typically appreciate over time. This equity helps alternative investments remain resilient in the long term.
Best practices for investing in alternatives
When considering an investment in alternative assets, there are several best practices that can help mitigate risk and maximize potential benefits.
1. Understand your investment thesis and goals
Before you start investing in alternative assets, be sure you’re clear about why. What are you expecting to achieve with this investment? Are you looking for passive income, long-term growth, or something else? What investment strategy best aligns with your risk tolerance? What are your short- and long-term goals? Questions like these can help you develop a clear understanding of your investment thesis, which will allow you to better evaluate potential investments and make informed decisions.
2. Do your research
Once you are clear on how alternatives fit into your overall investment strategy, it’s time to do some due diligence. This process involves reviewing historical performance data for your chosen asset class and evaluating the track record of any professional advisors you chose to work with. Conducting thorough research will ensure you fully understand the implications of the investment you’re making.
When assessing an alternative investment opportunity, be sure you’re informed about:
Risks & challenges
Alternative assets can come with some unique demands and risks. If you invest in real estate, for instance, you must be ready to deal with tenants, potential market fluctuations, and property maintenance. Private equity, on the other hand, is highly illiquid and often requires a large initial investment. Make sure the assets you choose fit your financial and lifestyle goals.
A defining feature of many alternative assets is their lack of liquidity. These aren’t necessarily the types of investments you can convert to cash in a pinch. Transactions are often very large and complex, which means it may be difficult to respond quickly to market changes. When investing in any illiquid alternative, it’s worth considering what your short-term financial needs are and ensuring you have an exit strategy in place.
No matter what asset class you’re investing in, fees are a major consideration – and many alternatives involve relatively large fees compared with traditional assets. These are typically linked to the management and performance of your portfolio. Examine the fees associated with your investments carefully and evaluate whether the return justifies the outlay. An even better approach is to utilize investment platforms (like FranShares!) that offer a zero-fee model.
No one wants the IRS knocking on their door, so it’s absolutely critical to understand the tax implications of your investments. The U.S. tax code is extraordinarily complex and its treatment of alternatives varies. For instance, payments from real estate investment trusts (REITs) can constitute ordinary income, capital gains, a return on capital, or some combination of the three. In contrast, cryptocurrency is simply considered property under the current U.S. tax code and is subject to capital gains tax based on the holding period. A certified public accountant or registered investment advisor can offer guidance on what to expect for your investments come tax time.
Certain alternative assets are subject to less government regulation than a new investor may be accustomed to if they’ve only dealt with conventional investment vehicles. This lack of regulatory oversight can make it difficult to access information and accurately assess risks and the potential returns of an investment. Digital currencies, in particular, are not currently regulated in the U.S. and therefore should be approached with extreme caution. Whatever the type of alternative, review the regulatory requirements carefully, and consider whether the level of oversight offered for your chosen investment fits with your personal risk tolerance and goals.
3. Consider working with a professional
Investing in alternative assets can be more complicated than investing in traditional assets. If you’re having trouble deciding whether this is the right path for you or the best strategy to pursue, consider speaking with a certified advisor or asset manager. These professionals have the tools and experience to help you evaluate potential investments, allocate assets, and manage risk.
When choosing an investment advisor or wealth management firm, take your time to evaluate their experience and credentials to ensure they’re in line with your goals and expectations.
4. Monitor your investments regularly
While alternatives are typically part of a long-term investment strategy, it’s still important to keep an eye on your portfolio. Regular check-ins can help you assess whether your investments are meeting your goals and staying within your risk tolerance. Also, consistent monitoring ensures you’re ready to make changes based on your financial situation and market conditions, whether that’s reallocating capital to a different asset class or jumping at the chance to take advantage of a new opportunity.
Some final thoughts
Alternative assets present an excellent opportunity for investors to diversify, generate passive income, and hedge against both recession and inflation. And while this asset class comes with its own unique set of challenges, it is possible to manage overall risk by performing thorough due diligence and following the best practices we’ve outlined in this post. Investing in alternatives is a long-term strategy, and an equally long-term commitment to your investment thesis will help maximize your chances of success.
If you’re considering adding franchising to your portfolio as part of an alternative asset investment strategy, learn more about FranShares by speaking to our Investor Relations team.