Equity, bonds, and mutual funds are the best-known investment instruments. But there are several other instruments that you can invest in. They are collectively known as alternative investments.
In this section, we will discuss what are alternative investments and how to invest in some of the common alternative investments, namely exchange traded funds (ETFs), derivatives, commodities and private equity.
Exchange traded funds (ETFs)
An ETF is a special kind of mutual fund that trades like a stock and tracks the movement of an index, such as the Nifty or Sensex. ETFs only invest in stocks that make up the index they are tracking. For example, an ETF tracking the Nifty will only invest in the stocks that make up this index. You can buy and sell ETF units on the market, just like stocks. Since the ETF invests only in Nifty stocks, the price of its units will move according to the Nifty.
By knowing what are alternative investments and investing in ETFs, you can buy into the growth of an index as a whole, without individually investing in its stocks. Invest in ETFs if you have a hard time picking individual stocks or if you want to cut your trading costs. Some ETFs also track overseas indices, which gives you exposure to say US or European stocks. Like equity indices, there are also ETFs that invest in debt and gold. You can invest in gold ETFs if you want to invest in gold without buying physical gold.
One of the types of alternative investments are derivatives. These are contracts whose price depends upon (i.e. is derived from) the price of other assets, such as stocks, bonds, commodities, and currencies. You can buy and sell them on a derivatives exchange. They were traditionally used to mitigate (i.e. hedge) the risk of a sharp movement in the price of the underlying asset. But they are also popular as profit-making instruments.
There are major types of derivatives:
1. Futures – This is an agreement to buy or sell an underlying asset at a pre-decided price on a future date. Assume that you just bought a stock for Rs.100. You would make a profit if you sold it at a higher price later. But you would incur a loss if its price fell. You can mitigate this risk by buying a futures contract at say Rs.110. This would obligate you to sell the stock at Rs.110, irrespective of how its price changes. But it will ensure that you make a profit of Rs.10.
2. Options – These are similar to futures contracts, except that they give you an option instead of an obligation to buy or sell at a pre-decided price. The option to buy is called a Call option and the option to sell is called a Put option.
In the previous example, had you bought a Put option, you could have decided whether to sell your shares or not on the future date. If their price rose above Rs.110, you could have opted out of the contract and sold your shares in the open market at a higher price.
Any basic good that is used as raw material or input in the production of other goods or services is a commodity. Commodities can categorised into:
1. Metals – They are further categorized into base metals (like copper, tin, and zinc) and precious metals (like gold, silver, and platinum).
2. Energy – Crude oil, natural gas etc.
3. Agricultural commodities – corn, sugar, cotton, wheat etc.
4. Meat and Livestock – live cattle, lean hog, feeder cattle etc.
Commodity trades usually happen through the futures market. Commodity futures are contracts where the underlying asset is a commodity. They are mostly used for hedging by entities that deal in these commodities. For example, a cotton farmer may protect himself from a fall in the price of cotton by buying a cotton futures contract. However, you too can trade in commodity futures to profit from commodity price movements.
Private Equity (PE)
These are funds that invest in unlisted companies with strong growth potential. They have a high minimum investment threshold, which makes them viable only for high net worth individuals (HNIs). The manager of a PE fund is called general partner (GP). He also invests in the fund along with the other investors, who are called limited partners (LPs). In addition to investing the fund’s corpus and handling its administrative duties, the GP is responsible for defining how profits will be distributed among the LPs.
The aim of a PE fund is to build a portfolio of companies, just as you would build a portfolio of stocks. However, instead of buying a few shares, PE funds buy major stakes in these companies. At times, they also acquire whole companies. The idea is to bring together companies that can strategically benefit from each other by sharing their capabilities. Some of these funds are sector-specific. They only invest in one sector, such as IT or financial technology.
To sum up
The above-mentioned are some of the alternative investments in India. Including secure alternative investments and assets in your investment strategy is a good way to diversify. The price dynamics of commodities are very different from equity, bonds, and mutual funds. They are a high risk-high return asset class. Adding a small proportion of these can boost your portfolio returns, even if you are a low-risk investor.
Disclaimer: Investments in the securities market are subject to market risks. Read all the related documents carefully before investing.