Demystifying alternative investments in a changing market
In the search for yield, interest in nontraditional assets has grown.
With investment-grade yields currently lower than inflation and interest rate increases on the horizon, people are looking for an option other than bonds. While they’re not for everyone and carry some tradeoffs, alternative investments are an area of growing interest for those curious about venturing further afield. It helps to have a trusted guide, like your advisor, by your side.
In the fall, the Securities and Exchange Commission’s Asset Management Advisory Committee approved a recommendation to expand access to private investments, noting in a report that select types yielded better returns than those in the public markets over periods of three years or more and can diversify holdings.
Underground to mainstream
The 13 million accredited investor households in the U.S. have not shied away from nontraditional assets of late, with “alt” investments flourishing in 2021, according to data from Robert A. Stanger & Co. Investors poured $80 billion into retail alternative investments from January to November 2021, compared with $10.8 billion for all of 2020. Much of that went to non-traded real estate investment trusts and interval funds.
Managers of these funds can invest in illiquid assets, including private companies, farmland, timberland and private debt, to scratch the surface. As a tradeoff for accepting a lower level of liquidity (redemptions may only be allowed periodically and in limited quantities), investors anticipate, but may not receive, higher returns than in the public markets – what’s called the “illiquidity premium.”
Though they have advantages, alts have some drawbacks. Many have high minimum investments and fee structures compared to traditional mutual funds. They are also less liquid, locking up capital for a predetermined amount of time to allow managers to take a long-term view in creating value. Finally, there are tax issues to consider. The taxation of alternative investment gains varies significantly, so consulting with a tax professional on the potential tax consequences is a smart move.
Non-traded real estate investment trusts
Real estate is the original alternative asset, with academic analysis showing that it can serve as an inflation hedge. Non-traded real estate also tends to have low correlation to equities and bonds, which helps diversification.
That explains some of the recent popularity of non-traded real estate investment trusts (REITs). These generally own income-generating real estate, such as office buildings, warehouses, shopping centers, apartments or hotels, making them a popular option for those seeking income. Non-traded REITs aren’t listed on a public exchange and are valued based on the value of the underlying investments, and not public market sentiment.
However, it’s important to read the fine print. Fees, especially upfront charges, can be high in comparison with traditional investments. Liquidity is another consideration. Non-traded REITs have monthly liquidity compared to the continuous liquidity of a publicly traded REIT, and will only redeem up to 5% of the fund’s value per quarter. While this may not be an issue when there is liquidity in the market, an investor could have their redemption prorated in severely stressed markets.
Private credit funds
Private credit, also known as private debt or non-bank lending, is an asset class made up of currently higher yielding, illiquid investment opportunities in various areas of the debt structure of corporations or real assets. Private credit funds tend to offer a higher yield as they are investing in less liquid credits. The funds tend to offer monthly or quarterly redemptions, or in some instances, no redemptions at all, which allows them to stay fully invested and potentially take advantage of market dislocations when they arise. Private credit funds can hold everything from senior to distressed debt, so risk and returns vary.
Substantial due diligence is critical in this area of investing. Because the lending is to non-rated entities, it can be challenging to determine credit risk. Then there is the complexity around fees to consider. These funds differ widely in fees, risk exposure and credit quality.
A guided approach
In the ever-evolving markets, there is always something new to discover, including ways that qualified investors can potentially add value to their portfolios. Though you should be mindful of the tradeoffs in this corner of the investment universe, you never know when having an understanding of the alternative investments space might come in handy. If you are curious about whether this approach may be suitable for your investment strategy, reach out to your advisor. They can provide you with insight and advice on how to potentially capitalize on the opportunities available.
Past performance may not be indicative of future results. Diversification does not guarantee a profit nor protect against loss. While interest on municipal bonds is generally exempt from federal income tax, it may be subject to the federal alternative minimum tax, or state or local taxes. Profits and losses on federally tax-exempt bonds may be subject to capital gains tax treatment.
Alternative investments involve specific risks that may be greater than those associated with traditional investments and may be offered only to clients who meet specific suitability requirements, including minimum net worth tests. You should consider the special risks with alternative investments including limited liquidity, tax considerations, incentive fee structures, potentially speculative investment strategies, and different regulatory and reporting requirements. You should only invest in these strategies if you do not require a liquid investment and can bear the risk of substantial losses. There can be no assurance that any investment will meet its performance objectives or that substantial losses will be avoided.