Alternative investments are categorized as financial instruments that do not fall in the traditional category stocks, bonds or mutual funds. Alternative investments could include hedge funds, commodities, real property, tangible assets, private equity, and venture capital to name a few. Investors seeking to diversify from traditional funds tend to add alternative investments into their portfolios.
Accredited Investors
Often referred as “exempt securities”, alternative investments are not publicly traded and nor easily accessible in a similar fashion to stocks, bonds or GICs. These investments are often limited to institutional firms and high net worth accredited investors.
An accredited investor is an individual, entity or institution that meets certain income, financial or net assets criteria. In Canada, the exact definition of an accredited investor can be found in section 1.1 of the National Instrument 45-106. There are over 20 situations in where a person might qualify as an accredited investor.
These types of investors are allowed to invest in alternative investments that may not be available to an ordinary investor . The most common criteria used are mentioned below.
- Income Criteria
- Your income before taxes has been at least $200,000 or greater in the last two years and you expect to earn the same level of income this year; OR
- You and your spouse have earned at least $300,000 or greater before taxes in the last two years and you expect to maintain the same level of income this year.
- Financial Assets
- You and your spouse have financial assets worth at least $1 million before taxes, net of related liabilities
- Cash and cash equivalents would be considered liquid or financial assets.
- You and your spouse have financial assets worth at least $1 million before taxes, net of related liabilities
- Net Assets
- You and your spouse have net assets of at least $5,000,000
- Fixed and liquid assets would be included to meet this exception.
- You and your spouse have net assets of at least $5,000,000
- Other Criteria
- For a list of other criteria, please refer to the National Instrument 45-106.
Types of Alternative Investments
Qualified investors are eligible to purchase alternative investment products in order to add extra diversification into their portfolios. They include a range of debt and equity instruments such as bonds, mortgages, real estate partnerships, income funds, labor sponsored funds, oil and gas flow-through shares and hedge funds. Below, we’ll list the most common type of securities that you might run into in the exempt market.
Hedge Funds
Hedge funds are alternative investments that pool investors’ dollars and invest them into various financial instruments. Hedge funds try to generate positive return, regardless of market direction by taking advantage of arbitrage opportunities, using long and short strategies and utilizing options, to name a few.
Asset-Backed Securities
Asset backed securities are complex investments that are backed by an underlying financial asset. These financial assets are a group of illiquid assets which are unable to be sold individually. Common asset backed securities include credit card loans, mortgage, loans, auto loans, home equity loans, etc.
Real Estate
Investors can invest in real estate which is a broad market. This can range from buying a property to more complex such as Real Estate Limited Partnership Units. (RLPU).
Real Estate Partnership Units – RLPU is when a group of investors buy real estate for the purpose of generating a cash flow and long term appreciation. Interested investors would participate in the project and be rewarded if the project or investment is successful, either on the back-end or on the disposition of the asset.
Real Estate Investments Trusts – REITS are also a popular investment product. REITS allow investors to participate in the distribution of rental income of the underlying properties. They trade similar to stocks and can either be public or private. Private REITs are available only to accredited investors mentioned above.
Private Placements
Private placement is when a company raises money through a non-public offering. They’re typically offered to a small number of investors which includes friends, family, accredited investors and institutional investors. Private placements are attractive to wealthy and knowledgeable investors as they typically allow for the purchase of stock at discounted prices while offering warrants to purchase additional stock in the future.
Venture Capital
Venture capital is a form of private equity financing that is provided to early stage, start up and emerging companies who are believed to have the potential for growth.
Commodities
Investors can invest in commodities through futures contracts or exchange traded funds. Commodities include agricultural products such as corn, wheat, soybeans, pork bellies, etc. Precious metals such as gold and silver are commodities as well. Trading commodities involves taking a position whether the price of a specific commodity will rise or fall. Be aware that trading commodities is high risk and not for a novice investor.
Flow Through Shares
Flow through shares provide a tax incentive to investors who acquire them. Companies in the mining, oil and gas and renewable energy are allowed to issue flow through shares to help finance their projects. These companies typically struggle to raise capital to finance their exploration and development activities which is why flow-through-shares are attractive.
Benefits of Alternative Investments
- Adding alternative investments to your portfolio can enhance the diversification of your portfolio.
- Alternative investments may provide you with higher level of return as you’re taking on more risk.
- Alternative investments may be negatively correlated to the overall market thus providing with you with a lower volatility.
Drawbacks of Alternative Investments
- Liquidity might be an issue. Alternative investments may have a holding period of days, months or even years.
- Portfolio managers utilize complicated investment strategies that an average investor would not understand.
- The more complicated the investment strategies are, the higher the fees. Alternative investments have a higher transaction cost and high management fees.
- Alternative investments may be exempt from prospectus disclosure requirements. The lack of transparency may be an issue for some investors.
