Alternative Investments

Alternative investments are asset classes outside traditional stocks, bonds, and cash equivalents. They include real estate, hedge funds, private equity, venture capital, commodities, precious metals, collectibles, and digital assets. Understanding these investments is essential for comprehensive wealth management and the CFP exam.

Why Alternative Investments Matter

Alternative investments serve several portfolio functions:

• Diversification: Low correlation with traditional assets can reduce overall portfolio volatility
• Inflation protection: Real assets like real estate and commodities often hedge against inflation
• Enhanced returns: Access to private markets may offer returns above public market averages
• Income generation: Real estate and certain hedge strategies provide cash flow

However, these benefits come with significant trade-offs including illiquidity, higher fees, limited transparency, and complex tax treatment.

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Accredited Investor Requirements

Many alternative investments are only available to accredited investors as defined by SEC Regulation D. This designation exists because private offerings have fewer disclosure requirements than public securities.

Individual Qualification Criteria

An individual qualifies as an accredited investor by meeting ANY of these criteria:

Entity Qualifications

Entities may qualify as accredited investors if they:

• Are trusts, LLCs, or partnerships with total assets exceeding $5 million
• Are entities in which all equity owners are individually accredited investors
• Are banks, insurance companies, registered investment companies, or employee benefit plans with assets over $5 million

CFP Exam Tip: The net worth calculation EXCLUDES the primary residence. Memorize both income thresholds: $200,000 individual, $300,000 joint.

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Real Estate Investments

Real estate is the most common alternative investment, accessible through both direct ownership and pooled investment vehicles.

Direct Real Estate Ownership

Owning physical property provides:

• Rental income stream
• Potential appreciation
• Tax benefits (depreciation deductions, 1031 exchanges)
• Inflation hedge (rents and values tend to rise with inflation)

Challenges of direct ownership:

• Large capital requirements
• Illiquidity (can take months to sell)
• Management responsibilities
• Concentration risk
• Transaction costs (6% typical broker commissions)

Real Estate Investment Trusts (REITs)

REITs are companies that own, operate, or finance income-producing real estate. They provide real estate exposure with stock-like liquidity.

Key REIT characteristics:

• Must distribute at least 90% of taxable income to shareholders to maintain tax-advantaged status
• Traded on major exchanges (publicly traded REITs) or available as non-traded offerings
• Professional management handles property operations
• Diversification across multiple properties

Types of REITs:

REIT tax considerations:

• REIT dividends are generally taxed as ordinary income (not qualified dividends)
• The 199A pass-through deduction may allow a 20% deduction on REIT dividends
• REITs in retirement accounts avoid the ordinary income treatment

Real Estate Valuation

The income capitalization approach values property based on its income-generating potential:

Property Value = Net Operating Income (NOI) / Capitalization Rate

Net Operating Income (NOI) = Gross Income - Operating Expenses (excluding debt service and depreciation)

Example: A property generates $200,000 in NOI. With a 10% cap rate:

• Property Value = $200,000 / 0.10 = $2,000,000

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Hedge Funds

Hedge funds are private investment partnerships that use sophisticated strategies to generate returns. They are lightly regulated and available only to accredited investors and qualified purchasers.

Hedge Fund Characteristics

• Private placement: Not registered with the SEC; limited to accredited investors
• Flexible strategies: Can use leverage, short selling, derivatives, and concentrated positions
• Performance focus: Aim for absolute returns regardless of market direction
• Limited liquidity: Often require lock-up periods of 1-2 years with quarterly or annual redemption windows
• Minimum investments: Typically $100,000 to $1 million or more

The "2 and 20" Fee Structure

Traditional hedge fund fee structure (multi-strategy funds increasingly charge higher effective fees through pass-through cost arrangements):

Example: A hedge fund with $10 million in assets earns a 15% return ($1.5 million gain).

• Management fee: $10,000,000 x 2% = $200,000
• Performance fee: $1,500,000 x 20% = $300,000
• Total fees: $500,000 (5% of assets, 33% of the gain)

Common Hedge Fund Strategies

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Private Equity

Private equity (PE) involves investing in companies that are not publicly traded. PE firms acquire companies, improve operations, and sell for a profit.

Private Equity Characteristics

• Long-term commitment: Typical holding periods of 5-10 years
• Capital calls: Investors commit capital that is drawn down over time as investments are made
• J-curve effect: Returns are often negative in early years due to fees and capital deployment, then positive as investments mature
• Illiquidity: No secondary market for most PE interests
• High minimums: Often $250,000 to $1 million or more

Types of Private Equity

Private Equity Fee Structure

PE funds typically charge:

• Management fee: 1.5-2% annually on committed capital
• Carried interest: 20% of profits above a preferred return (often 8%)

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Commodities and Precious Metals

Commodities are raw materials or primary agricultural products that can be bought and sold.

Commodity Categories

Investment Methods

1. Futures contracts: Most common method; requires understanding of contango, backwardation, and roll costs
2. Commodity ETFs: Track commodity indexes or specific commodities
3. Commodity stocks: Invest in companies that produce commodities (miners, energy producers)
4. Physical ownership: Direct purchase of precious metals

Precious Metals as Investments

Gold and silver are often viewed as:

• Inflation hedges
• Safe-haven assets during market turmoil
• Currency debasement protection

Key considerations:

• No income generation (no dividends or interest)
• Storage and insurance costs for physical metals
• Collectibles tax rate (28% maximum for physical precious metals held over one year)

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Collectibles and Other Alternatives

Collectibles

Collectibles include art, antiques, wine, classic cars, coins, stamps, and sports memorabilia.

Characteristics:

• Highly illiquid with no standard market
• Valuations are subjective and volatile
• Requires expertise to avoid fraud and overpayment
• Storage, insurance, and authentication costs
• Tax treatment: 28% maximum capital gains rate for long-term gains

Cryptocurrency

Digital assets like Bitcoin and Ethereum have emerged as a new alternative investment category.

Key considerations for CFP professionals:

• Extremely high volatility
• Evolving regulatory framework: The GENIUS Act (July 2025) established federal stablecoin oversight; SEC shifted from enforcement-first to rules-first approach; Bitcoin and Ethereum ETPs approved for in-kind creations/redemptions
• Custody and security challenges
• Tax treatment: Property for tax purposes; each transaction may trigger gain/loss recognition
• CFP Board guidance emphasizes fiduciary duty when advising on crypto-related assets

CFP Exam Tip: The CFP Board's Notice to CFP Professionals emphasizes the duty of care when providing advice on cryptocurrency, requiring understanding of the risks, regulatory environment, and client suitability.

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Liquidity and Risk Considerations

Comparative Liquidity

Risk Summary

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Portfolio Role of Alternatives

Alternative investments typically comprise 5-20% of a diversified portfolio for suitable investors. Their primary benefits include:

1. Correlation diversification: Many alternatives have low correlation to stocks and bonds
2. Return enhancement: Access to alpha opportunities not available in public markets
3. Inflation protection: Real assets provide purchasing power protection

Suitability considerations:

• Investor must meet accredited investor requirements
• Long time horizon to weather illiquidity
• Sufficient liquid assets for emergencies
• Understanding of risks and complexity
• Appropriate place in overall asset allocation