The possibility of economy-wide post-pandemic inflation with rising prices, increasing interest rates, and higher unemployment rates has left investors rightfully worried. While the rising inflation is by all estimates just a temporary trend as economies reopen, investors should still keep a watchful eye on the global events and do what they can to protect their investments.
Although no investment is a sure thing, there are always ways to minimize losses and ensure some profits – inflation or not. The best strategy is to diversify the portfolio with non-traditional (alternative) assets.
Let’s see what they are, how inflation impacts them, and what risks and benefits they carry.
What are non-traditional assets
Investors have the option to invest in conventional assets such as stocks, bonds, and cash. However, they also have an array of investment opportunities outside these limited categories, and these investments are known as alternative or non-traditional assets. They include hedge funds, managed futures, real estate, private equity, and foreign exchange/currency, among other things.
Non-traditional assets present an array of benefits and offer excellent opportunities for investors to boost their ROI.
Among the most popular alternative assets are hedge funds. Usually structured as limited partnerships, hedge funds use pooled funds to earn active returns and minimize risks for investors. In most instances, they can provide consistent returns regardless of the market conditions, hence the name “hedge,” since the investors take the position to offset their gains and losses.
However, due to their nature as private limited partnerships, hedge funds aren’t available to everyone. Only accredited investors with an annual income of over $200,000 in the past two years or those with a net worth of over $1 million (excluding personal residence) can invest in hedge funds. Investors who meet these stringent criteria will also need to prepare to cover exceptionally high fees while taking on significant risks.
Although hedge funds have received a lot of negative attention since the 2008 financial crisis, they can be valuable investments, especially for those worried about the effects of inflation on traditional assets. Initially, they were designed to mitigate the market risks of large companies, and they could do the same for individual investors.
Managed futures have significantly grown in popularity over the past couple of decades. They’re an ideal alternative to hedge funds as they offer a clean portfolio diversification.
Trading managed futures directly exposes investors to various markets, including energy, agriculture, commodities, and currency. To get started with managed futures, an investor needs to work with commodity trading advisors (CTAs) or futures commissions merchants (FCMs). As their name would suggest, industry experts actively manage managed futures.
Since managed futures tend to have an inverse relationship with stocks and bonds, they enable investors to round out their portfolios and minimize potential losses in the case of inflation as economies get back on their feet post-pandemic.
Although most beginner investors see real estate as a traditional asset since it’s such a typical investment, it’s categorized as an alternative asset. Furthermore, it could be the key to overcoming any inflation concerns.
Real estate is a unique alternative asset category because it shares similarities with both bonds and equity. On the one hand, investors and property owners can boost their recurrent cash flows with rent. On the other hand, they could increase the long-term value of real estate and enjoy capital appreciation.
Investors could invest in real estate products like residential apartments, vacation homes, office buildings and collect returns by renting, selling, or even house flipping. Another option is using brokers and investing in real estate investment trusts (REITs).
Additional options for investing in real estate include real estate partnerships/joint ventures, impact investments, and hard money loans.
As a general rule of thumb, real estate values tend to increase in higher inflation as landlords drive up the costs of renting. Additionally, REITs have proven to be lucrative in the past during periods of rising inflation, so there’s no reason to believe they would underperform today whether the rising inflation is just a temporary trend or a severe issue.
Private equities are long-term investment opportunities that come as high-risk/high rewards. Instead of having investors use publicly traded stocks, they involve investing directly in different companies. In most instances, these companies use the invested funds to expand, improve their marketing, or even go forward with M&A plans.
Since investing in private equity tends to involve lengthy negotiation processes regarding share prices, most investors work with private equity firms instead of directly with the companies in question. Private equity firms collect the investors’ funds then invest them into different businesses.
Investors can make private equity investments through:
- Distressed funding:
- By investing in a failing company to boost its sales and build equity;
- Leveraged buyouts:
- By buying a failing company and selling it for a profit;
- Fund of funds:
- Using private equity to invest in asset types like hedge funds (ideal for investors otherwise struggling to get into hedge funds).
Other subsets of private equity include venture capital (focusing on startups) and growth capital (focusing on established companies with expansion/restructuring plans).
Foreign exchange/currency trading, also known as Forex trading, is another non-traditional asset that could be an excellent option for investors worried about inflation. It involves buying and keeping a large sum of money in a foreign currency, making it a long-term investment different from conventional cash investments.
Forex trading or hedging most commonly involves currency pairs like EUR/USD, GBP/USD, and JPY/USD, although any currency pair is technically an option.
In the past few years, a subcategory of Forex trading became exceptionally popular – Cryptocurrency trading. Cryptocurrency such as Bitcoin is easily accessible and one of the safest options since it’s based on Blockchain technology that makes it virtually impossible to counterfeit.
Moreover, cryptocurrencies (and the Blockchain network as a whole) are decentralized and independent from any government, so there’s no political interference that can impact them. Of course, cryptocurrencies carry their unique risks being extremely volatile, but they come with a great potential for reward.
Whether investors trade crypto or Forex, they aim to make a profit once the currency moves in the position they’re hoping for – up or down.
Impact of inflation on non-traditional assets
Non-traditional assets usually have a very low correlation to conventional asset classes like stocks, bonds, and cash. So, when market conditions change, such as inflation, they don’t always move in the same direction as traditional assets.
For example, when inflation rises, each dollar carries a lower purchasing power. Therefore, investors with income-generating stocks find less value in their stocks. Additionally, when inflation increases, the Fed tends to increase its interest rates, causing bond prices to go down. However, as an alternative asset, real estate tends to increase in value as inflation rises, and hedge fund managers often start thriving amid inflation.
As a general rule of thumb, many alternative assets perform well under inflation, but they carry other risks that investors need to consider.
Additional risks of non-traditional assets
Although higher inflation isn’t usually a concern for investors with non-traditional assets, these assets aren’t failproof. Some of their main risks are as follows:
- Most alternative investments aren’t regulated by the U.S. Securities and Exchange Commission (SEC) or the Financial Services Regulatory Commission;
- Most non-traditional assets are illiquid, making them difficult to sell quickly;
- There is a lack of independent research on non-traditional assets, so investors can only rely on information from the biased investment provider;
- The value of some non-traditional assets can be difficult to determine;
- There is a higher risk of scam with alternative investments;
- The minimum investment in non-traditional assets is typically much higher than in traditional assets.
Additionally, individual types of non-traditional assets have risks specifically associated with them. The managers of managed futures might not be using the best strategies to increase the investor’s ROI. Global and local market conditions, new laws and regulations, and more can impact a real estate investment value. Unexpected events can have a significant impact on the importance of foreign exchange/currency.
While alternative assets can often protect against the negative impacts of inflation, investors should be aware of the risks they are taking when making investments.
The benefits of investing in non-traditional assets
Despite the risks, non-traditional assets can bring many benefits that go beyond inflation protection:
- Portfolio diversification:
- Alternative assets enable investors to diversify their portfolios and minimize their losses if stocks, bonds, and cash start to lose their value;
- Lower portfolio volatility:
- Since alternative assets aren’t traded publicly, they don’t fluctuate as frequently as conventional investments (except for cryptocurrency, whose nature is already highly volatile);
- Traditional asset counterweight:
- The weak correlation between alternative and conventional assets means that the plummeting traditional assets won’t have much of an impact on alternative investments;
- High-risk/high reward
- Although minimal investment in alternative assets is high, automatically carrying higher risks, the potential rewards are increased.
Non-traditional assets are an excellent way to circumvent inflation concerns, minimize losses, and boost profits. While experts estimate that the rising inflation is a passing trend and that economies will rebound by the end of 2021, investing in alternative assets is still a smart choice for any investor looking to diversify their portfolio.