Equities, bonds, and investment funds form the foundation of many investment portfolios. However, financial markets offer a much wider range of investment opportunities, commonly referred to as alternative asset classes.
Alternative investments can provide diversification, exposure to different economic drivers, and additional opportunities for portfolio construction. While some alternative assets are widely used by institutional investors, others may involve higher levels of complexity and risk.
What You Will Learn
By the end of this chapter, you will understand:
- What alternative asset classes are
- The role of commodities and precious metals
- What real estate investments work
- What REITs are and how they differ from direct property ownership
- The basics of foreign exchange markets
- The purpose of derivatives
- The characteristics and risks of cryptocurrencies
Understanding Alternative Asset Classes
Alternative asset classes include investments that fall outside traditional equities, bonds, and cash instruments. These assets often behave differently from traditional investments and may respond to different economic and market conditions.
Investors sometimes use alternative assets to diversify portfolios, hedge against inflation, or gain exposure to specific sectors and themes. However, many alternative investments can involve greater complexity, lower liquidity, or higher volatility than traditional investments.
Examples of alternative asset classes include commodities, real estate, foreign exchange, derivatives, and cryptocurrencies.
Commodities and Precious Metals
Commodities are physical goods that can be bought and sold in financial markets. Common examples include oil, natural gas, wheat, coffee, and industrial metals.
Precious metals such as gold, silver, platinum, and palladium are often treated as a separate category due to their historical role as stores of value.
Investors may use commodities and precious metals as a hedge against inflation or to diversify portfolio risk. However, commodity prices can be influenced by factors such as supply shortages, geopolitical events, weather conditions, and global economic activity.
Key Definitions
Commodity: A raw material or physical good traded in financial markets.
Precious Metal: A naturally occurring metal valued for its rarity, industrial use, and investment demand.
Real Estate and REITs
Real estate has long been considered a popular investment asset class. Investors may purchase residential, commercial, or industrial properties with the objective of generating rental income or benefiting from property appreciation.
Direct property ownership, however, requires significant capital and ongoing management responsibilities. To address this, financial markets offer Real Estate Investment Trusts (REITs).
REITs are companies that own, manage, or finance income-producing real estate. By purchasing shares in REIT, investors can gain exposure to property markets without directly owning or managing physical real estate.
Key Definition
REIT (Real Estate Investment Trust): A company that owns or manages income-producing real estate and distributes a portion of its earnings to shareholders.
Foreign Exchange and Derivatives
The foreign exchange (Forex) market is the global marketplace where currencies are bought and sold. Participants include governments, central banks, financial institutions, multinational companies, and investors.
Currency values fluctuate based on factors such as interest rates, inflation, economic growth, and geopolitical developments. While foreign exchange markets are among the largest and most liquid markets in the world, they can also be highly volatile.
Derivatives are financial contracts whose value is derived from another asset, such as share, bond, commodity, or currency. Common derivatives include futures, options, and swaps.
Although derivatives can be used for risk management and hedging purposes, they are generally considered more complex than traditional investments and may not be suitable for all investors.
Key Definitions
Foreign Exchange (Forex): The market where currencies are traded.
Derivative: A financial contract whose value is linked to an underlying asset.
Cryptocurrencies
Cryptocurrencies are digital assets that use cryptographic technology and distributed ledger systems, commonly known as blockchain technology.
Bitcoin, introduced in 2009, was the first cryptocurrency and remains the largest by market value. Since then, thousands of cryptocurrencies have been created with varying purposes and characteristics.
Supporters view cryptocurrencies as an innovative asset class with potential applications in payments, finance, and digital ownership. However, cryptocurrencies are often characterised by high volatility, regulatory uncertainty, and significant price fluctuations.
For this reason, investors should carefully consider the risks involved before investing in digital assets.
Key Definition
Cryptocurrency: A digital asset that uses cryptographic technology to facilitate transactions and record ownership.
Alternative Assets in a Portfolio
Alternative assets can provide diversification benefits because their performance may not always move in line with equities and bonds. This can help investors spread risk across different sources of return.
However, diversification alone does not eliminate risk. Investors should consider factors such as liquidity, volatility, complexity, costs, and investment objectives when evaluating alternative asset classes.
The role of alternative investments within a portfolio will vary depending on an investor’s goals, risk tolerance, and investment horizon.
Key Takeaways
✓ Alternative asset classes include investments outside traditional equities and bonds.
✓ Commodities and precious metals can provide diversification and inflation protection.
✓ Real estate can be accessed directly or through REITs.
✓ Foreign exchange markets facilitate currency trading.
✓ Derivatives are contracts whose value is linked to an underlying asset.
✓ Cryptocurrencies are digital assets that can experience significant price volatility.
✓ Alternative assets can support diversification but often involve additional risks and complexity.
Next Chapter
Chapter 9 | Risk & Return
The next chapter explores one of the most important principles in investing: the relationship between risk and return, and how investors assess and manage investment risk.