Alternative Investments and Your Portfolio Part 2 – Risks of Alternatives and How to Fit Them in Your Portfolio

Part 1 of this series introduced alternative investments and explained why they are the hot topic right now. If you haven’t read part 1, click here 

Types of Alternatives

Just to remind you, here is the list of alternatives from part 1 of this series:

• Real Estate – investments in individual properties or a fund of properties.
• Commodities – buying and selling future contracts in hogs, copper, oil, gold, etc.
• Venture Capital – investing in start-up companies.
• Private Credit – loaning to companies who cannot borrow from banks or issue bonds.
• Private Equity – owning equity in companies which are not traded on the stock market.
• Hedge Funds – Funds which can buy (going long) stock or sell short (going short) stock. Also, can invest in other assets.
• Option Strategies – Using the options market to generate income, lower risk, or take risks on individual stocks or market indices.
• Managed Futures – Buying or selling short in the futures markets to follow trends in these markets. Could be commodity, currency, stock market, or other futures.
• Precious metals – Gold, silver, platinum, etc.
• Bitcoin and digital currency.
• Illiquid Assets – Farmland, Art, Wine, etc.

Risks

When you look at this list, you will notice that some of these investments seem risky. For instance, you would think Venture Capital is pretty risky. Is real estate risky? If you own your home, that’s a real estate investment. Do you think owning your home is risky? You might be able to answer that question better after reading this section.

I listed the risks in part 1 of this series, but in part 2 I want to break them down and explain them.

Liquidity Risk

Let’s say you own some rental property. This might be very lucrative for you if you can rent this property at good rates. But let’s say that you lost your job and need money right away. How quickly can you sell a property to get the cash you need? You might have to sell your property in a poor market or accept less than the market price to get the cash you need right away. In some circumstances, you may not be able to sell your property at all. That is liquidity risk and many of the alternative investments have poor liquidity. Real estate, venture capital, private credit, private equity, hedge funds, art, and wine may be very hard to sell when you need the money. Liquidity risk is closely tied to the next risk.

Pricing Risk

Everyone knows the stock market can be volatile. But the one good thing is that you always know what your investment is worth. The stock market pricing is amazingly transparent. But that is not true for many alternative investments. The worst offenders tend to be real estate, private equity, venture capital, and private credit. You buy into these investments, often into funds which cannot be sold. The only way to know how much they are worth is the reporting of the fund company. If you can’t actually sell the investment, then you have no way to know if this pricing is correct and in many cases it is not. In fact, that’s how these investments appear to be non-correlated with the stock and bond markets. It’s easy to appear non-correlated if pricing is inaccurate.

If your primary reason to invest in these alternatives is because they are not correlated, you need to be very careful. If your investment advisor recommends these investments for that reason, they are doing you a disservice.

Expenses

Alternative investment funds are almost always more expensive than stock or bond funds. This is to be expected because alternative funds tend to be actively managed and markets can be harder to access. Still, the costs can range from fairly reasonable to truly outrageous, so it’s a good idea to pay attention to expenses.

Private investment funds have historically charged “2 and 20”. That is 2% of assets each year plus 20% of the gains beyond a minimum threshold. Charging this way can align the interests of investors with the interests of the managers, but it will typically enrich the managers and if your fund just does OK vs. cheaper funds, you can find yourself paying significantly for mediocre performance. (See this Investopedia article for more info) Private Equity, Private Credit, Venture Capital, and Hedge funds often charge this way.

More and more alternatives are available in an Exchange Traded Fund. These funds tend to be much cheaper than private funds, so if you are considering a private fund, you really need to evaluate whether it’s worth it. ETFs will almost always charge less than 1%. A Managed Futures ETF that I use in some portfolios has a fee of 0.85%.

Risks of the Underlying Assets

It should seem obvious that when you invest in an alternative fund, you are exposed to the risk of the underlying assets in the fund. Unfortunately, those risks are sometimes hard to understand. Private credit is a good example. Private credit funds are making loans to private companies. The private credit funds promise higher yields than bonds and, in many cases, the loans are floating rate, so the interest rate risk is minimal. But think about why any company would agree to borrow from the private credit funds at higher and floating rates. It’s likely because they cannot qualify for credit from banks and are too small or too risky to be able to issue bonds, even high-yield bonds. The private credit fund investor has no way to evaluate all the loans in the portfolio to understand these risks. Every fund company that has presented to me has told me that their fund is “different”, and their diligence means lower risk loans. So far, I have chosen to stay away from private credit because I feel the risk is too high.

What’s to Like in Alternatives?

Despite all these risks, there are still alternative strategies that I like, although you need to incorporate them into a portfolio carefully.

Options Strategies

In particular, I favor options strategies that either increase income or hedge risks in portfolios. For instance, the insurance industry has been selling fixed-indexed annuities for years. These annuities promise you that your investment is linked to the S&P 500 (or another index) and that either your downside risk is buffered or that you cannot lose money over some time period, often a year. There are a lot of things that I don’t like about these annuities, but I like the original promise of limited downside risk in return for a cap on your yearly gains.

It turns out insurance companies use options strategies to implement these annuities and you can now buy the same strategies in the form of an exchange-traded fund (ETF). These ETFs are relatively low cost, tax-efficient, and can reduce risks in your portfolio. They are also completely liquid and don’t hide pricing. I often incorporate these strategies in portfolios I develop.

Managed Futures

Managed Futures is sometimes called “trend following” because an investment manager will use trends to inform their trading in commodity and other futures markets. You used to have to buy an expensive mutual fund or even private fund to invest in managed futures, but now there are ETFs you can buy to invest in this area. The big plus is that managed futures tend to not be correlated with stocks or bonds, so it’s a very effective alternative to those investments. There is a risk here. Managed futures can go down, sometimes over many months.

Commodities

Managed Futures funds buy and sell commodities. But you can just buy commodities if you want to use ETFs. You have a lot of possibilities, from broad commodity funds to funds which invest in a single commodity such as gold. The correlation between commodities and the stock and bond market varies. In 2022, commodities did very well, when the stock and bond markets did poorly. But during the COVID scare in 2020, commodities went down with the stock market. Bonds held up during this period. Managed Futures can be both long and short commodities, so they can be better, but you must trust that the fund managers make the right bets. In a straight commodity fund, you make money when commodity prices rise.

Real Estate

You can buy real estate in a liquid way, using publicly traded Real Estate Investment Trusts (REITs) or funds of REITs. You can also use private funds with no liquidity or interval funds which have limited liquidity once a quarter. All of these are legitimate ways to invest in real estate. Real estate prices do well when the economy does well and tend to hold up in some recessions but do poorly in others. Real estate tends to do poorly when interest rates rise.

With current conditions, office buildings have done very poorly because people are working from home. But residential rental real estate has done very well as have warehouses, medical, and industrial.

People think of real estate as holding value even when the stock market is very volatile. But the reality is that real estate is far more volatile than even the stock market, but over longer periods, can do just as well. Over the past 23 years, the Dow Jones Composite REIT index has gone up 537.7%. The S&P 500 total return index rose 592.44% over the same period. But the Volatility of the REIT index was 21.7% over that period vs. 17.8% for the S&P 500. It is also pretty correlated with stocks (from Kwanti).

Do Alternatives Belong in Your Portfolio?

I think the right alternative investments can improve a portfolio. It can increase diversification, lower volatility and even possibly increase long-term return. But you need to keep the risks in mind, make sure you are not paying exorbitant fees, and understand whether your investments are being transparently priced. If you give up liquidity in your portfolio, you had better be gaining something superior. For the right investor, a venture capital fund with zero liquidity and a 10 to 15 year timeframe might make sense. At the end of the long timeframe, that investor might make a lot of money. But for most investors, this would not be an advisable investment because of the high expenses and lack of liquidity.

An honest, experienced financial planner should be able to advise you on the best portfolio for you. Make sure your advisor explains these alternatives to you and how they make your portfolio better. If you want to discuss your portfolio with me or my colleague, Mike, please reach out to us.

Important Information

Cereus Financial Advisors, LLC (“Cereus”) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where Cereus and its representatives are properly licensed or exempt from licensure.

This article contains my views and opinions, which are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.  Past performance shown is not indicative of future results, which could differ substantially.

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