We've all heard the phrases "Timing is everything" or "It's better to be lucky than smart." In many respects, these sentiments could apply to investing in the stock market. To succeed, one might hope to have the knowledge or the luck to pick the very best time to buy and sell stocks. But, as another saying goes, "Hope is not a strategy."
So, how do we address the fact that we cannot consistently predict the perfect time to buy and sell an investment? One way is diversification. For many investors, diversification begins with allocating between both stocks and bonds. The idea is that these are categories that are not correlated, meaning that they usually do not move in tandem. The next level of diversification could be viewed as owning different types of stocks and bonds within these allocations.
This stock-bond allocation introduces tension: stocks tend to earn at much higher rates (over long periods of time) but are more volatile, while bonds offer more steady but generally lower yields. The challenge becomes balancing the desire for growth with the need for stability.
One way to reduce this tension between stock and bond allocations is to add another category for diversification: alternative investments. Alternatives can be broadly defined as any asset that does not fall into the category of being a stock or a bond. For many years, alternative investments were the domain of ultra-wealthy investors and large endowment funds:
- Recent surveys indicate that 69% of ultra-wealthy investors utilize alternative investments, while high net worth investors allocate alternatives to their portfolios only around 13% of the time.
- A study by MarketWatch indicates that the ultra-wealthy invest similarly to large endowment funds, as these endowments are invested in alternatives 65% of the time.
So, when does it make sense for a high-net-worth investor to add an allocation to alternatives to their portfolio? Given the broad definition, alternatives can even include assets such as fine art, vintage automobiles, timber, rare whiskey and others. A more practical approach narrows the focus to alternatives that historically:
- Exhibit less volatility than the stock market
- Offer net yields exceeding those of bonds
Following this logic, the list of options becomes considerably smaller. While there are many categories that follow this logic, two of the better-established ones are private credit funds and income-producing real estate funds.
Private credit
Private credit encompasses entities that are non-bank lenders, in many cases capitalizing on niches where traditional banks are not able to compete effectively. The market for lending outside of the traditional banking system was estimated at about $1.5 trillion at the start of last year, up from $1 trillion in 2020, and is projected to grow to $2.6 trillion by the end of 2029.
Private lenders pool capital from investors and lend those funds, charging a fee to operate the funds. Investors receive the difference between rates charged to the borrowers and expenses to operate the fund. Much like banks, private lenders have written loan policies, systems for collecting payments, and audit firms that review their books.
Based on industry benchmark data by Cliffwater, historical gross returns for private credit investments have been in the range of 8% to 10%. (This is usually recognized as ordinary income. Some private credit funds lend only against real estate and may be structured in a REIT, which could allow for some more favorable tax treatment.
Private real estate funds
Individuals interested in real estate might consider purchasing a commercial or residential rental property. In this scenario, not only would it require time and expense to manage the property, but your investment would be allocated to a single property with all of the risks that go with that concentration. Not to mention, most individual investors lack the required professional knowledge and experience to maximize returns on real estate investments.
A more practical approach for investing in real estate is a fund structure, such as a non-traded REIT. These funds are managed by real estate professionals, invest in many different properties and property types, bring scale to transactions due to their larger size, and offer much easier entry and exit to real estate investments than direct ownership. Many of these funds are managed in a tax-advantaged manner whereby their distributions to investors are considered a return of capital. For example, this feature could result in a 6.5% distribution rate from a fund having an equivalent tax adjusted yield of 10% for someone in a 35% tax income tax bracket.
Strategic takeaways for investors
The right alternative investments can play a significant role in both reducing volatility and enhancing the overall yield of a portfolio. Specifically, private credit and real estate funds can be viewed as less complex than other alternative asset categories and can often provide a steady return with minimal fluctuations (if any) in value. Since there are many choices within these categories, it's best to work with an advisor who understands the landscape. Wealth advisors affiliated with a Registered Investment Advisor firm must ensure that they are fully transparent in terms of fees and pricing and must ensure their recommendations align with the client's financial goals.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
