What Advisors Should Look for in an Alternative Investment
The demand for alternative investments has surged over the last few decades, with this growth expected to continue in the years to come. Prequin estimates the market for alternatives will reach $14 trillion by 2023. To put that into perspective, this amount is roughly half the entire current market cap of the NYSE, and greater than that of the NASDAQ. Exposure within portfolios is growing as well. The most successful university endowments have been known to allocate as much as one-third of their portfolio to alternatives.
Before we discuss the benefits behind this increasing demand, let’s define what we mean by “alternatives.” This broad category includes traditional alternatives such as hedge funds, private equity, real estate, managed futures, and commodities, as well as newer or more obscure investments such as art, cryptocurrencies, timber, storage facilities and peer-to-peer lending. Alternatives were traditionally only available to ultra-high net worth investors, but this continues to change as firms like Origin Investments recognize increased demand and break down barriers to entry.
So what are the benefits that have drawn such attention, and how could they help your clients achieve their investing goals? Three key benefits that many alternatives provide include the ability to generate significant returns, risk mitigation, and a low correlation to stocks and bonds. Let’s explore each of these in detail.
Generating Significant Returns
In an environment where major asset classes trade at high valuations, we can find better value in alternative investments that have not had such a run-up. This value can lead to higher returns over time if pricier asset classes see a retrace in valuations. The stock market (S&P 500) is currently sitting right at all-time highs. The chart below shows the valuation (price to earnings ratio) of the S&P 500 over the past 100 years. The price to earnings ratio for the index sits just above 29 (as of 8/17/2020), trading above its 5-, 10-, 15- and 20-year averages.
In addition, bonds have had a large run over the years as interest rates have continued to fall. (Bond prices move inversely to interest rates.) This year alone, the benchmark 10-year Treasury rate had fallen an additional 70% from January 1st to July 31st. This makes for a relatively expensive entry point for fixed income, which can hurt long-term returns for the asset class and any portfolio significantly allocated to bonds.
One of the attractions of certain alternative investments is their ability to generate outsized returns. Certain alternatives tap into markets with less participants, which are therefore less efficient. This can make for attractive valuations of certain assets, which then makes for attractive relative returns over time when compared to other investments.
At Origin Investments, we invest in direct private real estate. We take a special focus on multifamily housing properties in the markets where we see the most significant population and employment growth forecasts. When underwriting investments, expected return is one of the key criteria that we screen for. Will this investment complement our portfolio of properties by adding the alpha that we are looking to provide for investors? Nearly 60% of the deals we have sourced have been off-market transactions. This means they are even less followed than the broad commercial real estate market, and this enables us to access exclusive opportunities at what we consider very attractive price points. Better entry points help enhance our clients’ long-term returns.
A second benefit that advisors can look to alternatives for is their ability to mitigate risk. Some alternative asset classes may not be focused on maximizing growth, but more so on lowering the average risk of the aggregate portfolio. When it comes to long-term investing, the focus should not lie solely on achieving the highest returns possible, but also on doing so with as little risk as possible. Risk-adjusted returns are the key to a successful investment portfolio.
We can measure risk by volatility, or how much the price of a security or group of securities changes in price. An investment with less volatility will provide a smoother ride than one with higher volatility. Not only will this investment ease the anxiety of the investor, but it may provide higher returns over time.
Deep pullbacks require significant returns to fully recover. For example, during the Great Recession of 2008, the S&P 500 experienced a roughly 53% pullback from October 2007 to March 2009. To recover to its prior level, it would require roughly a 110% cumulative return. The S&P 500 did not accomplish this until March of 2013, or about four years after it bottomed. Investments that experienced less downside would need less of a recovery to make an investor even.
Downside protection is a centerpiece to how we invest at Origin. We accomplish this with risk management tactics that include moderate use of leverage, conservative modeling to prepare for any element of uncertainty, and strategic capital structuring, to name a few. This enables us to limit downside in the bad times so that we have less ground to make up in the good times. This mentality has also helped us never miss or reduce our monthly distribution for the Origin IncomePlus Fund.
Low Correlation to Stocks and Bonds
In addition to the risk of an individual security or asset class, advisors should evaluate how a potential investment complements the other asset classes their clients are exposed to. As we just discussed, lower risk in an investment can add significant benefits over time. This holds true at the overall portfolio level as well. Having more diversification in your clients’ portfolios can greatly benefit them at times when the stock market or bond market experience large pullbacks. When one asset class struggles, it helps to have exposure to others that will struggle less, or better yet, do well.
One key way to measure diversification is through correlation, which measures the degree to which two securities move in relation to each other. A correlation of 1.0 implies that two assets are perfectly correlated to each other, so pairing them together would provide no diversification benefits. A correlation of 0 implies that they experience no correlation. A negative correlation would mean that they are inversely correlated and thus move in opposite directions. The best diversification comes from securities or asset classes that experience low or negative correlations to each other, but this can be difficult to achieve in the current market. Even stocks and bonds, two asset classes known to have negative correlations to each other, will often move in tandem at times. Alternatives offer a low correlation to stocks and bonds, which can dampen this risk.
At Origin, one of the major advantages that we see in multifamily housing is its low correlation to equities, fixed income, and even public real estate securities (REITs). The matrix below shows correlation numbers for multifamily housing (NPI- Apartments) for the 20-year period ending June 30th of this year. You can see that multifamily has had only a 0.17 correlation to the broad stock market (Russell 3000), a 0.28 correlation to publicly traded real estate (FTSE Nareit All Equity REITs Index), and a negative correlation to bonds (Barclay’s Aggregate Bond Index).
20 Year Asset Correlation Numbers
|Russell 3000||Barclay’s Aggregate
|FTSE Nareit All Equity
Certain alternative investments can offer additional benefits beyond the three previously discussed. While inflation has been low for the last several years, some fear that it may pick up with the amount of stimulus provided by Congress and the Federal Reserve. Real estate and other real assets can serve as an effective inflation hedge as their valuations participate in the growth of prices. Other investments, such as bonds and cash, will see their purchasing power decay at these times, and will thus lose value.
Alternatives can provide powerful tax benefits as well. The Origin Income Plus Fund provides a 6.4% distribution and writes off depreciation and other expenses to offset the majority of this income. This creates great tax efficiency for the end investor, which passes through to their K1. In addition, our buy and hold strategy for the fund limits capital gains (and transaction costs), which can otherwise serve as a major drag on performance. These benefits can add up to significant gains over an extended period of time.
Finally, one less quantifiable benefit that alternatives can provide to clients is the ability to partake in a new and exciting opportunity that they find interesting. The investment landscape is one that is ever-changing. There will always be new ideas that thrive and need capital along the way. Alternative investments provide a means for your clients to take part.
The market for alternatives has come a long way since the turn of the century. As we discussed, they provide a multitude of benefits to an investment portfolio, but they come in many different forms that all have their own complexities. As an advisor or investor, it is important to do the due diligence to take note of which benefits you are looking to incorporate and which alternatives asset classes will provide those benefits.