The term Alternative Investment covers all investment assets outside of the traditional ‘big 3’ of cash, bonds and equities and therefore defines an enormous investment sector, which can overlap with the big 3 too.

Alternatives can include: commodities, derivatives, structured products, private equity, hedge funds and real estate. Art, antiques and other valuable collectables could also be considered as alternative investments. Generally these types of investment have fairly low levels of correlation with the traditional asset classes. This means that if equities or bonds may fall in value the alternative assets may also fall or may go up but are not strongly linked. This means that these sorts of investments can be very good diversifiers in a portfolio.

Commodities are ‘raw materials’ which are produced, priced and traded all over the world. They can be agricultural or precious and their prices are set by supply and demand. Demand can change dramatically on the back of unusual events, such as bad weather or they can be seen as a ‘safe haven’ during a financial crisis. An overlap with the equity market occurs here as many company shares perform on the back of the commodity that they are involved with e.g. a gold mining company.

Derivatives are financial instruments, such as forwards, futures, options, and swaps. Their values are based on the changes in values of other assets such as commodities, equities, residential mortgages, properties, bonds, interest rates, indices or other tradable items. All types of derivative can be used to manage risk or to speculate on the expected future values of the ‘underlying’ asset. A common term associated with derivative investment is hedging because they can provide a positive return even if the other asset value falls…hedge the bet!

Hedge funds are investment funds which are permitted to employ a wide range of unusual investment strategies to provide returns. They tend to only be accessible by professional or very wealthy investors. Hedge funds often aim to provide stable returns or reduce risk by hedging their investments. They are very much under scrutiny at the moment and have suffered greatly during the credit crisis, though this does not mean that they are not worth looking at. Many ‘absolute return’ strategies can provide excellent risk control within a portfolio.

Private Equity – this is the investment into the “equities” (shares) of a company which is not actually quoted on a stock market, and is therefore “private”. Due to the nature of this strategy one can invest into very young and therefore potentially profitable businesses. The strategies in private equity investments include venture capital, leveraged buyouts and distressed investments.

Property, whether it is commercial (office blocks, factories) or residential, can be an excellent addition to a portfolio. Commercial property tends to have very low correlation to other assets and can provide a good and increasing income as well as potential for capital growth. The credit crisis has affected the property sector considerably due to the drying up of the credit markets but over the long term can be a very good investment.

Historically, accessing these types of alternative investments has been expensive and often requiring high minimum investment levels. Now nearly all asset classes are accessible through quoted funds. This allows a modest investor to pick a fund which may employ several strategies from different sectors which can then be placed into the portfolio alongside normal equity and bond funds. For example there are now funds which invest in the climate change or agricultural sectors, or which use derivatives to trade in the gold and platinum markets.

There are even some funds which build a whole portfolio in one, drawing upon huge global expertise to invest across all asset classes – equities, bonds, property, commodities, private equity etc.

In another article we consider how this can be done through sensible asset allocation and portfolio construction.

This article is for information only and should not be considered as advice.

Peter Brooke is a financial planner to the English speaking expatriate community. He is based on the Cote D’Azur and is a member and partner with the Spectrum IFA Group. He can be reached on +33 6 87 13 68 71 or peter.brooke@spectrum-ifa.com or at www.spectrum-ifa.com/riviera.html

This article was published in the June 2009 edition of Dockwalk magazine.