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Other Types of Investments

What is it?

Although investors typically put their money into stocks and bonds, many other types of investments exist that can be used to diversify investment portfolios and meet the objectives of businesses, individual investors, and portfolio managers alike. However, most of these investments are complex and should be used only by sophisticated investors.

Hedge funds

Hedge funds are private investment companies that manage money for institutions and wealthy individuals. While they have some similarities to mutual funds, hedge funds are offered only to limited numbers of qualified investors, not to the general public. As a result, hedge funds are subject to fewer regulations than mutual funds and have at their disposal a wider range of investment techniques. Hedge funds also have far higher minimum investment amounts than typical mutual funds.

Derivatives

A derivative is a financial instrument whose value is based on another financial instrument. Derivatives popular with investors include commodity and financial futures, options, swaps, and collateralized mortgage obligations, to name just a few. Derivatives are used as a hedge by businesses, portfolio managers, and some individual investors to reduce risks from price fluctuations (e.g., currency exchange rates, interest rates, commodity prices, equity prices). They can also be used by investors who want to make money by speculating on the movement of these prices. Participants in the derivatives market are usually knowledgeable investors who have the resources necessary to absorb significant losses.

Commodity and financial futures

Investors who are looking for high rewards are sometimes attracted to futures, contractual agreements that promise future delivery of something--a commodity (e.g., a grain or a metal) or a financial instrument (e.g., a security or a currency)--upon a certain date, at a specified price. Futures contracts are standardized and are traded on organized exchanges. Although the futures market was originally created to facilitate trading among individuals and companies who produce, own, or use commodities in their businesses, the market has expanded to include individuals and companies that buy and sell futures contracts as a way of investing.

Options

Options are contracts that give an investor the right (but not the obligation) to buy or sell an asset at a specified price within a certain time period. Options are traded on exchanges and over-the-counter markets. Types available include equity (stock) options, index options, interest rate options, and foreign currency options.

Options are versatile investments that allow investors to tailor their portfolios to personal investment objectives. An investor can purchase a call, which is the right to buy an investment at a specific price within a certain time period, or purchase a put, which is the right to sell an investment if it decreases in value within a certain amount of time.

Securities backed by pools of debt instruments

Pass-through mortgage securities
Mortgage-related securities (securities backed by mortgages) include certificates issued by the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac), the Federal National Mortgage Association (FNMA or Fannie Mae), and the Government National Mortgage Association (GNMA or Ginnie Mae).

Collateralized mortgage obligations and real estate mortgage investment conduits
Mortgage-backed securities may be pooled to create collateral for more complex types of mortgage securities known as collateralized mortgage obligations (CMOs) and real estate mortgage investment conduits (REMICs). These attract investors who would otherwise be put off by the regulated cash flow and fixed maturity dates of traditional mortgage pass-throughs. Because they restructure interest and principal payments into separately traded securities with several classes or "tranches" (each having a different coupon rate, average life, prepayment terms, and final maturity), they meet the needs of different types of investors. For more information, see Mortgage-Related Securities, Securities Backed by Pools of Debt Instruments, and Real Estate Mortgage Investment Conduits.

Nonmortgage assets
Aside from mortgages, individuals can invest in other types of debt instruments, including automobile loans and credit card receivables, equipment leases, student loans, junk bonds, and delinquent tax liens, to name a few.

Securities backed by pools of insurance policies

Looking to reduce financial risk and find new sources of capital, insurers have developed two methods of converting insurance risk into securities that can be sold to investors. Under the first method, specific pools of risk are put into securities with payment structures that depend on the performance of those pools. Under the second method, catastrophic bonds, called CAT bonds, are sold to investors whose rate of return depends on the loss experience of insurers.

Unit investment trusts

Like mutual funds, unit investment trusts (UITs) buy pools of securities--usually stocks and bonds--then sell an interest in them to investors. However, unlike mutual funds, which can buy and sell frequently and are actively managed, UITs buy securities only when the trust is first created, then hold them for a specified period of time (usually one to five years). There is no buying or selling of assets by the UIT during the life of the UIT, except in limited circumstances, nor is there any active management.

UITs give investors the chance to buy blue chip stocks at affordable prices. There are many popular types of UITs, including Standard & Poor's Depositary Receipts (SPDRs, pronounced "spiders"), Diamonds (which track the performance of 30 large blue chip stocks on the Dow Jones Industrial Index), and the Nasdaq 100 Trust (which invests in the top 100 nonfinancial stocks that trade tech-heavy and fast-growing companies on the Nasdaq).

Stock market certificates

Stock market certificates (also known as market participation certificates, equity index certificates, or market index certificates) are short-term investments available to individual and institutional investors alike. A stock certificate's earnings rate is tied to an index (typically Standard & Poor's 500 Composite Index). If the index goes up, the investor's dividend rate goes up. If the index goes down, the investor earns no dividends but doesn't lose his or her investment.

Because they let investors reap potentially higher returns through the stock market without risking their initial investments, stock market certificates are attractive to inexperienced and conservative investors, as well as those seeking a hedge in their investment portfolios. However, they are typically used as investment vehicles for qualified retirement plans.

Hard assets

Hard assets are tangible, physical assets bought and sold for investment purposes. Although many types exist, those popular with investors include collectibles, precious metals and gems. Investors buy hard assets to diversify their portfolios because the performance of hard assets is often opposite the performance of stocks and bonds. They can be enjoyable and reassuring to own, and they tend to retain their value or even appreciate as inflation rises. They may generate high returns, although their value can be unpredictable.

Limited partnerships

Limited partnerships appeal to investors who want to share in a business's financial success, but who don't want to actually run the business or be fully liable for its debts and obligations. As limited partners, investors provide the capital to fund the business and hope to profit if it does well. Although they've fallen out of favor in the last decade (the Tax Reform Act of 1986 curtailed their ability to shelter cash flow), limited partnerships are still attractive to investors who want to diversify their portfolios. Shares in a limited partnership are purchased through a securities broker-dealer or a financial planner, and frequently require that investors meet minimum net worth, income, and tax bracket criteria.