Even if they don’t practice it, almost every investor has heard of diversification. For most investors, diversifying their assets is limited to stocks and funds from different industries, sectors, indices, etc.
But if you are not satisfied with diversifying within the same asset and want to explore the risk and returns of different asset classes, it is high time you considered alternative investments in Canada.
Alternative investments are huge in North America, and US and Canadian investors make up about 64% of the global alternative investment market.
What is an Alternative Investment?
Anything that’s not one of the three traditional assets (stocks, bonds, and cash) is technically an alternative investment. Traditional investments are available to the public and open for all. Anyone can buy and trade them. Traditional investment assets are properly regulated (typically by government institutions and stock exchanges).
Alternative assets, however, are different. While some alternative “assets” (if you stretch the definition far enough) might be available for everyone with enough cash, most alternative investments are not. They are also not bound by the same rules (and regulations) as traditional assets are. This is one of the reasons they are also called “exempt securities.” Entities offering these securities and assets are not bound to present a detailed prospectus and provide disclosures like companies offering their shares in the market are.
That doesn’t mean that alternative investments are the wild west of the investment landscape. It’s a business transaction, and if someone who is trying to attract alternative investors is purposely keeping them in the dark or being deceitful about an asset, they are unlikely to go too far. But it does mean that a novice investor might not be equipped (or have the resources) to invest in alternatives.
These investments are typically open only to a specific class of investors (usually with substantial funds at their disposal). These investors understand the alternative investment assets, associate risks, return potential, and typically have enough funds to cover a sizeable part of alternative investments.
The value of these investments cannot be shredded into tiny little pieces and sold in the market (like shares of a company). Limiting the number of investors is beneficial for both everyone: Neither the asset value nor the returns are diluted.
Another distinction is that alternative investments do not necessarily follow the current market trends and help you make money even when the stock market can’t. Alternative investments include hedge funds, derivative contracts, cryptocurrencies, commodities, collectibles, and ironically, real estate. Ironic because real estate “investing” is centuries older than stock exchanges.
Accredited Investor Vs. Eligible Investor For Alternative Investments
Before we dive into the select group of people who are allowed to invest in alternative assets (and what makes them unique), it’s essential to understand that not every alternative investment requires you to follow specific requirements before you are allowed to buy them.
For example, if you are buying cryptocurrency, holding on to it, and selling it for a profit, this would fall under the umbrella of alternative investment. Still, you don’t have to be an “accredited” or “eligible” investor for it.
So who are these accredited and eligible investors anyway?
According to the Ontario Securities Commission Prospectus exemption (NI 45 106), an Accredited Investor is someone that:
- Is registered as an advisor or a dealer under Securities act, or
- Has a net worth of $5 million (alone or with a spouse), or
- Has net financial assets worth at least $1 million. That doesn’t include primary residence, or
- Net income (before taxes) of more than $200,000 a year (or $300,000 household income).
There might be some other stipulations as well, depending upon the particular alternative investment you are going for, but even that should give you an idea that it’s an exclusive club. These investors are expected to have enough assets and liquidity to absorb the financial fallout of a risky alternative investment.
That poses a two-way problem. Not many people can invest in alternative assets and entities that are offering these assets have a very limited pool to reach out to. In order to widen that pool, another class of investors was introduced, called eligible investors.
These investors can’t trade as freely and as much as accredited investors, but certain exempt investments are available to them under something called “offering memorandum.”
An Eligible Investor is someone who:
- Has a net worth of $400,000 (individually or combined),
- Has yearly income more than $75,000 individually or $125,000 as a couple in the past two years, with reasonable surety that the individual (or couple) would make at least that much or more in the coming years.
Even though eligible investors don’t have access to all the alternative assets that accredited investors can invest in, and they may not be able to invest as much as an accredited investor, they can still be part of the game.
Pros and Cons of Alternative Investments in Canada
Each alternative investment has its individual merits and weaknesses, but there are certain pros and cons that they all share. Understanding them can give you an idea of whether or not you want to try going for an alternative investment.
- Asset-wise portfolio diversification.
- Little correlation to broader market volatility and movement.
- High returns compared to traditional investments (usually).
- You can make more money in less time.
- Access to specialist, niche investment managers.
- High risk (hence high reward).
- Stringent qualification requirements (for some alternative investments).
- Significantly more experience, knowledge, and research required, or
- Higher investment management/advice fees.
- Less transparency.
- Illiquid and hard-to-liquidize assets.
List of Alternative Investments
There are plenty of alternative investments available. Some are only available to the accredited or the eligible investors, while some are less discerning.
1. Venture Capital
Liquidity: Concrete mix (Very illiquid. Returns can take years)
Think Shark Tank. A person, a startup, or a very young business comes to you for capital. You have the money, you like their idea, you are impressed by what they have done with limited resources, and you are reasonably sure that they could be huge in a few years, so you give them the money they need to take off the ground. If they succeed, you may see returns anywhere between three to ten times the capital you’ve invested.
But what if the business fails? After all, about eight out of ten startups tend to fail. If it fails, all your money is down the drain. You might recover some assets or part of the failing business, but it would barely be pennies on the dollar.
This risk is why you get such high returns and why most Venture Capitalists (VCs) invest in multiple businesses. The idea here is to have at least enough investments that even if more than half of them fail, the rest can make up for the losses.
Another problem why only institutional investors or some very high-value investors try their hand in Venture capital is the technical/business acumen needed to assess the market and potential of a new business or product.
That’s what VC firms specialize in: assessing promising startups to invest in. That’s what sets venture capital apart. They invest primarily in startups and when the businesses are in early stages, i.e., seed funding or Series A funding. The risk is highest, but so is the return potential. But it could take years for the business to offer you the promised/expected returns.
2. Hedge Funds
Liquidity: Ketchup (Funds get locked up for a while, typically a year, and withdrawals are periodic after that).
Hedge funds used to be the cool kids or, as one definition eloquently put it, the “biker gangs” of investment funds. But that’s not the case anymore. The “hedge” lost its “edge” in the market boom after the great recession.
The concept of a “hedge” fund is that they offer protection against market downturns, and not like safe-haven investments like gold do. A hedge fund can be a basket of derivative products, options, leverages, exempted securities, and many other non-traditional assets. It’s kind of similar to mutual funds, but where the underlying assets in mutual funds are mostly securities, underlying assets in a hedge fund can be a wide variety of assets.
This complicated management and risky investment strategies allowed hedge funds to charge a premium to their investors. It also means that only accredited or eligible investors might be able to invest in a hedge fund.
3. Real Assets (Commodities)
Liquidity: Honey to alcohol (depending on the market can be very fast to sell, sometimes very difficult)
This one is open for all, and many investors actually do have gold and silver (either as jewelry or bullions). These precious metals provide an excellent hedge against the market dynamics (as the 2020 gold price hike has proved). Still, they might not offer excellent returns compared to some other alternative investments.
Other commodities include oil, livestock, corn, etc. Basically, anything you can buy and sell in the open market. However, most investors don’t actually take possession of the underlying commodity (too much hassle) and invest in options to buy and sell. Commodities can offer powerful returns on rare occasions.
They are low-risk because, in a lot of cases, even if you can’t sell your commodities at a higher price, the risk of losing all your capital is low (but still there). They can be very liquid if the demand surges but difficult if the demand suddenly drops. That’s what happened to oil companies and distributors in 2020.
4. Real Estate
Liquidity: Honey (usually takes time to return your capital)
Real estate is easily the most known and recognized alternative investment, and it comes in various shapes and sizes. The simplest is that you buy a home, shop, office, etc. and rent it out for a consistent income stream. You can also buy land or property, get it renovated and sell it for a higher price. Or you can simply benefit from a property’s value appreciation.
It’s another alternative investment that’s not exclusive to the accredited or the eligible investor. However, these guys play on a different level. Many accredited investors usually get into what is called syndication deals.
These deals allow a group of investors to pool their money and buy a sizeable property (multifamily, apartment buildings, offices, logistic properties, etc.), earn rental income from it, and sell it after a while for a decent profit. In the US, these kinds of deals and paper losses (depreciation losses) allow investors to save A LOT of money in taxes.
One flaw in real estate is that it can be challenging to sell, and you may have to wait months before your capital is back in your hands.
5. Private Equity
Liquidity: Concrete-mix (very low)
Private equity is sort of a superlative of venture capital. Private equity firms and investors target mature or distressed businesses that are not publically traded, offer them capital, which either helps them grow, improve, or survive.
Another difference here is that private equity firms typically invest in conventional businesses and mature industries and not disruptive and unique startups.
This investment is typically secure because investors are well-versed in what changes they can make (with their capital) in a business to make it more profitable.
A private equity firm can fully acquire a business, make it profitable and sell it, or they can simply provide capital to a distressed company, leaving it autonomous. The real cost here is liquidity. If you want to pull your money out, you have to sell your stake, and it doesn’t usually doesn’t sell at a very high margin.
6. Crypto, Fine Arts, and Collectibles
Liquidity: Low-High (depends on the asset)
You don’t need to be an accredited or eligible investor to invest in collectibles, fine arts, and cryptocurrencies, but these are unconventional and tricky investments, even among the alternative investments.
Crypto is the easiest to understand. Even if a whole Bitcoin is very expensive, you can look into other cryptocurrencies and how they are moving against the dollar. You can buy Bitcoin (or another crypto), wait for it to appreciate, and sell it to a broker like BitAccess.
You can also incur a loss, and Bitcoin profits/losses might be taxed a bit differently from other investments. It’s also highly volatile.
Collectables like toys, coins, first editions, art pieces, rare watches, and a lot of other things can be sold for a very high margin. The rarer something is, and the more familiar you are with the potential buyer pool, the better your profit margin can be. But it takes a rare eye, a particular set of skills, thorough research, or all three to make a profit in collectibles, rare items, and arts.
If you are planning on engaging in alternative investments in Canada (whether or not you are an accredited/eligible investor), the first thing to do is do your research.
If you are chasing higher than traditional investment profits, you also have to make sure that the risk is worth it.