Alternative investments are well-suited for diversification because, by their very nature, they are typically less volatile and less correlated to the stock market.
Their reduced volatility is due to their typically long investment horizons, which require investors to commit for a set period. Valuations are also more fundamental rather than being influenced by momentum trading or animal spirits.
Alternative investments are less correlated to stock markets because of these long investment horizons and because they are often in niche sectors or built on unique innovations.
Alternative investments could offer not only greater risk protection, but also often outperform the market. An estimate by Preqin demonstrated that alternative investments outperformed the S&P 500 by 137.8 percent over the last 20 years. Smart investors are enjoying a win-win by drinking from the Holy Grail and experiencing lower risk and higher returns as a result.
S&P 500 vs Private Equity over the last 20 years
So, what types of alternative investments are the ultra-wealthy investing in? When we lift the bonnet of their alternative investment portfolios, the following asset classes emerge:
• Private equity
• Private debt
• Private real estate
• Hedge funds
Pre-IPO and private equity are where the big money is made on fast-growing startups. In the past, these startups were listed much earlier, providing a rocketship return for small investors. Nowadays, startups are fed so many more rounds of VC funding that many have little immediate interest in an IPO. As a result, unicorns are routinely minted, while remaining private and out of reach of small investors.
Private debt involves loaning funds to private companies. Historically, private debt was seen as the last refuge of desperate companies. However, the past two decades have seen enormous growth in the private debt market. This form of investing provides companies with greater flexibility and more attractive conditions than the traditional banking sector. For the investor, large returns are available with better security than investing in a stock.
Real estate is king, but true loyalty lies at the top end of the market. Large commercial, retail, and luxury developments can be very lucrative. While "location, location, location" is important, profits are made in proportion to the vision and scale of the investment. In addition, real estate can be a helpful hedge against inflation because house prices and rental income tends to rise with inflation.
Hedge funds are specialized funds that combine various arbitrage strategies to achieve returns no matter whether the market is moving up, down, or sideways. Their reputation took a hit because of the 2008 crisis, but successful hedge funds like Bridgewater still attract big money from eager investors.
Commodities include metals, oil, and agricultural products. Some investors buy physical commodities, such as gold, while many others trade commodities using options or ETFs. Commodities are great for diversification and hedging against inflation.