Alternative investments are any investments other than traditional stocks, bonds, and cash equivalents. Ultra high net worth investors may choose to utilize these instruments to strengthen the diversity of their portfolios, potentially gaining more opportunities for growth and improved risk management. Two key types of alternative investments you might want to consider are private equity and hedge funds.
What Are Alternative Investments?
Most investors at every resource level have standard traditional investment instruments in their portfolios, and these can be used to fulfill a solid, diversified investment strategy. However, investors with significant assets may have access to more diversifying options, which can have multiple benefits:
- Allowing for heightened risk management at times when stocks and bonds are moving in tandem (counter to their traditional relationship)
- Offering more opportunity to seek higher risk-adjusted returns, especially in market downturns
- Help mitigate overall portfolio volatility
Alternative investments include commodities like wheat, oil, coffee, etc.; commercial or residential real estate; cryptocurrencies; collectibles like vintage cars or art; and private equity and hedge funds.
Private Equity: A Long-Term Growth Strategy
What Is Private Equity?
When you buy stocks, you are investing in public companies that are traded on an exchange. When you make a private equity investment, you are putting your money into private or possibly public companies that are not listed on an exchange. Private equity provides financing that enables these companies to grow.
How does private equity work? Private equity firms buy companies and overhaul them to increase their value and earn a profit when the business is sold again. To raise money to acquire and improve these companies, private equity firms establish and manage private equity funds into which you can invest if you have the long-term investable assets required.
There are different types of private equity deals. The basic type is the buyout, in which a private equity firm acquires an entire business it believes is underperforming. Here are some subtypes:
- Growth equity is a form of buyout involving companies past their start-up phase but needing help to grow.
- Leveraged buyouts are acquisitions funded by a significant amount of debt as well as investor equity.
- Carve-outs involve purchasing part of a company, usually a subsidiary or non-core business unit.
- Venture capital, often considered a separate but related category of investment, focuses on startup companies.
Why We Believe Ultra High Net Worth Investors Should Consider Private Equity
You may want to consider private equity because it offers the potential for significantly higher long-term returns than traditional public market investments. The private equity firm establishing the investment fund purchases undervalued businesses and actively manages the investment, using organizational efficiency and innovation to increase value. This can be particularly important when the stock and bond markets are volatile or underperforming.
However, you should also consider the illiquidity of these investments. While stock and bond investors have flexibility in how much they invest and for how long, private equity asset class investors are usually required to commit significant capital for years. This is why access to such investments is limited to institutions and individuals with high net worth. If you decide to participate in private equity, allocating resources you do not anticipate needing for several years is essential.
Hedge Funds: Managing Risk and Seeking Market Independence
What Is a Hedge Fund?
A hedge fund is a private investment fund that pools money from wealthy investors to seek returns outside of traditional markets. Participation is limited to investors who can meet certain financial requirements for income, net worth, or asset level.
Hedge funds depend on sophisticated trading and risk management strategies. These may include:
- Long/short equity strategies: taking long positions in stocks expected to increase in value and short positions in stocks expected to decrease
- Event-driven strategies: seeking to exploit pricing inefficiencies that may occur before or after a corporate event
- Arbitrage: simultaneously buying and selling an asset in different markets or derivative forms to profit from differences in price
- Credit strategies: profiting from inefficiencies in debt instruments
- Niche strategies: focusing on specific, small market niches
- Global macro: seeking profits based on global economic trends
The Role of Hedge Funds in UHNW Portfolios
Hedge funds are actively managed. Fund managers are experienced in using complex strategies and watch the markets closely for unique opportunities for their qualified investors. They then try to produce above-market returns.
Seeking higher returns usually requires a higher level of risk tolerance, and this is true for hedge funds. However, as the name indicates, in addition to looking for above-market returns, these managers are also concerned with “hedging” against losses, and many of their strategies are designed to do both simultaneously.
This focus on downside protection makes hedge funds especially appealing during periods of market volatility. The goal is to keep your portfolio growing steadily rather than experiencing the constant ups and downs of a volatile market.
Liquidity is always a consideration in investing. Hedge funds can be either liquid or illiquid, depending on the assets they hold and the strategies they employ.
Private Equity vs. Hedge Funds: Is Either Right for You?
When trying to decide which type of alternative investment is right for you, you should think carefully about your risk tolerance, liquidity needs, and investment time horizon. For private equity or hedge funds, you need a significant level of investable assets and some risk tolerance. These instruments are not designed to be your only or core investment strategy. However, they can be important accessory strategies in your overall financial plan.
For example, if you have a large bucket of assets you know won’t be needed for the next five years but that you’d like to see grow substantially, private equity could be a good option. The private equity firm that manages the fund is in the business of making companies more profitable and will put all of its resources and actions behind the effort to increase return on investment. However, remember there is still potential for losses and that this can be an all-or-nothing strategy. If the company you’re backing succeeds, you could do well. If it fails, your losses could be significant.
If you need more liquidity for your assets or are more focused on risk management for your entire portfolio, a hedge fund may be a better choice for you. However, be careful to choose a hedge fund manager that fits your goals. Check on the liquidity, timeline, and risk profile of the assets within the fund. In this case, find one that offers better liquidity and a strong focus on asset protection.
How to Find the Right Alternative Investment Strategy
Alternative investments can be complex and sophisticated. Before you invest, it’s important to understand all the ramifications. Working with an experienced financial advisor can help you understand and navigate these strategies and their relationship to your overall financial plan.
Strategic asset allocation among multiple asset classes can significantly affect how your portfolio performs and how effectively you meet your financial goals. A wealth advisor with experience and an understanding of the unique needs of ultra high net worth investors can be a good partner in helping you make the most of both traditional and alternative investments to achieve your goals.
To be custom-matched with an advisor you can trust to support your goals with customized investment planning, explore Carson’s advisor matching program today.
Some alternative investments involve a high degree of risk, and returns can be volatile. Investing in an alternative investment may only be suitable for persons who are able to assume the risk of losing a portion or all of their entire investment.
A diversified portfolio does not ensure a profit or protect against loss in a declining market.
The return and principal value of bonds fluctuate with changes in market conditions. If bonds are not held to maturity, they may be worth more or less than their original value.
All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful.
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