01/24/2017 01:53 pm ET Updated Jan 25, 2018

5 Common Alternative Investments All Investors Should Know

Broadly speaking, alternatives are investments in assets other than stocks, bonds and cash (commodities, for example) or investments using strategies that go beyond traditional ways of investing, such as long/short or arbitrage strategies. Because alternatives tend to behave differently than typical stock and bond investments, adding them to a portfolio may provide broader diversification, reduce risk, and enhance returns.

Alternative investments include venture capital, private equity, hedge funds, real estate investment trusts (REITs), commodities, as well as real assets such as art, wine, and high jewelry. These assets usually perform with low correlation to stocks and bonds, and are generally more illiquid than traditional investments. Alternative assets often mitigate market volatility present in more traditional investments similar to those found in public markets.

The Yale endowment model is a case study which explains some benefits of hedge fund and private equity allocation. The Yale allocation to private equity is 33% of its $23.9 billion endowment fund, representing a significantly larger allocation than other educational institutions. The Yale endowment generated 20.2% in returns in fiscal 2014, far outpacing most endowments, and has gained 11% every year for the past 10 years.

1. Private Equity
Private equity is a broad term encompassing the entire investment spectrum of the private capital markets, and different private equity firms specialize in multiple investment strategies. Private equity firms typically raise funds and take capital from both non-institutional and institutional investors. The funds will then be used to place investments in promising private companies. The capital is returned to investors upon an exit event such as an IPO or acquisition after the firm takes its management and performance fee.

2. Venture Capital
This is a subset of private equity specializing in the investment in early-stage to growth-stage companies. Firms will specialize in early stage investing, raising funds from high net worth and institutional capital and deploying them to companies ranging in industry, geography, and funding stages. This capital source is very important for start-ups and early-stage companies that have no access to public financing as many lack extensive operational or revenue history. Venture capital is typically a risky asset class, but can produce outsized returns upon a successful liquidity event.

3. Hedge Funds
These are pooled investment funds that are created to invest in a variety of strategies and asset types. Hedge fund managers raise funds and invest with a variety of styles and financial instruments. Some of the more common hedge fund strategies include equity long-short, distressed assets, arbitrage, and macro-trends. Hedge funds differ from private equity and venture capital funds as they invest in public equities and generally have greater redemption frequencies and liquidity, meaning investors can get their money out more often.

4. Art
Art is a real asset with a real valuation. Other examples of real assets include real estate, wine, and jewelry. Arthena's art collections capture value by penetrating the highest growth area of the art market - Post-War and Contemporary, amongst other periods such as Modern and Emerging. Arthena seeks to provide diversification across the many sub-areas of this specific art market segment through our collections. In 2013, the population of HNWIs numbered 13.7 million while their wealth soared to $53 trillion. According to the 2015 Capgemini World Wealth Report, the HNWI population grew 6.7% to reach 14.6 million in 2014, while its total wealth grew 7.2% to $56.4 trillion. Art alone has grown to account for nearly 17% of high net worth individuals' investments in the years leading up to 2014.

5. Private Placement Debt
Investment in debt is also a large market in the alternatives space. Similar to equity, private placement bonds are not issued or traded publicly, and are not required to be rated by a credit rating agency. Promissory notes or mezzanine debt are often used to finance a private company, while giving investors a steady stream of cash flows.

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