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What Are Alternative Investments? Meet Institutional Investors’ Best-Kept Secret (Until Now)

Post on September 6, 2022 in Blog

Institutional investors have long used alternative investments to diversify their portfolios beyond traditional publicly traded stocks and bonds. In fact, most institutional investors have placed 10 to 50 percent of their funds in alternative investments. But what are alternative investments? And how can everyday investors take advantage of these powerful investment opportunities?

Institutional Investors Choose Alternative Investments

Investment professionals from various disciplines are quickly coming to recognize the importance of investing in alternatives as institutional investors, family offices, and university endowments are decreasing their public market commitments and increasing their capital allocations across alternative investments.

The Yale endowment fund is a stunning example of this. David Swensen, the former Chief Investment Officer at Yale University, pioneered “The Yale Model,” a strategy that prioritizes portfolio diversification by allocating a greater percentage of the endowment to alternative investments.

In 1989, nearly 75 percent of the Yale endowment was committed to U.S. stocks, bonds, and cash. Today, domestic marketable securities account for less than 10 percent of the portfolio, while foreign equity, private equity, absolute return strategies, and real assets represent over 90 percent of the endowment.

According to the Yale Investments Office, the heavy allocation to alternative investments was chosen due to their “return potential and diversifying power.” In fact, the endowment saw an astounding 40.2% return in the 2021 fiscal year due in part to its alternative investment allocation.

Family offices such as Omidyar Network and Bezos Expeditions are making more and more investments into startups, compared to traditional investments. They are seeing the value in the returns from startups and are willing to take that risk. In fact, in the past few years, family office deal volume outpaced traditional venture capital firms, according to Crunchbase.

The Public Market Is Shrinking

This shift in investment practice is due to several fundamental changes in the investment landscape. First and foremost, fewer companies are going public, which reduces the likelihood of catching a unicorn in the public market. In the 1990s, there were roughly 8,000 publicly traded companies, a number that has steadily declined since. Further, a study by a finance professor at Arizona State University showed that since 1926, only four percent of all companies generated the U.S. stock market’s total 10% average annual return.

At the same time, as access to venture capital has become more readily available, companies have opted to stay private for longer, shifting profits to the private markets.

Because of the infusion of venture capital, many companies are achieving the majority of their growth while still being privately held. This limits the potential return for investors who only make equity investments in companies on the public market-when growth has already begun to plateau.

Self-Directed IRAs Offer a Way Into Alternative Investments

Self-directed IRAs offer the opportunity to diversify a retirement portfolio into alternative investments with holdings other than the mutual funds, stocks, and bonds that comprise most IRAs and 401(k)s. These alternative investments can include:

  • Startups, private equity, and venture capital
  • Residential and commercial real estate
  • Farmland and other land or mineral rights
  • Shares of securitized art
  • Crypto assets and funds

While some alternative investments can be higher-risk securities, often due to their illiquidity characteristics, these opportunities offer diversification and returns in many cases beyond traditional holdings.

Many people consider their IRA to be an untouchable pool of capital. There is often a risk-averse mentality that surrounds retirement funds. This often causes even sophisticated investors to believe their IRAs are best served sitting in publicly traded assets, split between stocks and bonds, and letting compound interest work its magic.

But the truth is that the returns of a 60/40 portfolio (60% stocks, 40% bonds) may no longer be sufficient to satisfy long-term investment objectives. For example, a 2022 JPMorgan study predicts modest 4.3 percent returns over the next 10 to 15 years for portfolios with a 60/40 allocation.

With this in mind, it’s no wonder many are turning to alternative investments using self-directed IRAs to achieve their financial goals.

Alternative Investments Are Not Only for Institutional Investors

Until recently, the opportunity to invest in these privately held companies, and other alternative assets, had been limited to institutional investors, like Yale, and ultra-high net worth individuals.

With the implementation of Regulation CF in 2016, this is no longer the case. Regulation CF is the set of rules governing equity crowdfunding and allows people outside of venture capital to invest in early-stage companies, as well as other alternative investment opportunities.

With Alto, knowledgeable investors can now access alternatives by allocating a portion of their IRAs in alternatives the same way institutional players, like the Yale endowment, have been doing for decades.

All investing involves risk, and investors need to evaluate their risk tolerance and objectives before investing in alternatives and public securities alike. That said, both investors and investment data agree that a diversified portfolio is not only the best way to mitigate risk but also a tried-and-true method for producing the strongest returns.

Add Alternative Investments to Your Portfolio With Alto

At Alto, we’re on a mission to help people use their savings to invest in the kinds of assets that interest them, and in doing so, diversify their portfolios. That means offering tools that are easy to use and access and providing educational resources (like this blog) on the many alternative investment options available within a self-directed IRA.

You can diversify your investment portfolio with Alto in two ways:

  • Alto Crypto IRA®: Buy and sell 200+ crypto assets tax-free or tax-deferred through Coinbase integration.
  • Alto IRA: Invest in a variety of private asset classes through our investment platform partners.

To start investing in alternative assets with your IRA, open an account today.