Think about the characteristics that make a strong portfolio: diverse, cost-efficient, tax-efficient, risk-managed. These qualities should be true of every portfolio, no matter the size or an individual's risk profile. The clients we meet with all want a portfolio that checks these boxes, but doing so is easier said than done. This is why we often look to alternative investments. The world of alternatives provides access to unique opportunities that, when used correctly for the right investor, can help achieve the portfolio traits mentioned above.
The catch-all phrase of "alternative investments" is a bit of a misnomer, since it can mean different things to different people. Hedge funds are alternative investments, as are structured settlements and cryptocurrency assets. The reason we preach the value of alternatives to certain clients is because they can have a low correlation to the U.S. stock market, which comprises many investors' main risk exposure. Achieving an asset mix with low correlations helps protect against downside and bouts of volatility, especially as traditional assets are becoming more correlated than ever. As BlackRock noted, alternatives took less heat during the dot-com crash and financial crisis compared to their mainstream peers. On top of this, alternatives can generate higher rates of returns due to the wide scope of their investment universe. But of course, not all alternatives are created equal. With this in mind, there are two types of alternatives we feel make a strong case for portfolio inclusion: real estate and private debt.
Perhaps the most well-known type of alternative investment, real estate investing has become increasingly popular in recent years. We find real estate attractive in part for its returns. The 20-year average returns of REITs (11.8%), residential real estate (10.6%) and commercial real estate (9.5%) all outperform the S&P 500 (8.6%). The total equity market cap of the FTSE Nareit All REITs Index is over $1.1 trillion, according to the National Association of Real Estate Investment Trusts, more than double the market's $438 billion value in 2007. However, the rising popularity of real estate investing has had an unintended consequence: It has increased real estate's correlation to equities and the overall market. This can be problematic for us, as we are generally trying to diversify away from equities when including a real estate allocation in a client portfolio. This is why we prefer to allocate to nonpublicly traded real estate funds rather than publicly traded REITs. Private placement real estate gives us access to institutionally managed real estate assets directly valued by leading firms without having to worry about external market forces having an impact on price and volatility. It's a best-of-both-worlds solution for our investing needs.
In the wake of the financial crisis, many traditional lenders scaled back their business lending activity, paving the way for institutional funds and investors hungry for entry into the private lending markets to get a bigger piece of the pie. And the market is expected to continue to grow, both in the U.S. and abroad. A 2017 report from the Alternative Investment Management Association said the global private credit market will break the $1 trillion threshold by 2020. Why would investors flock to such an obscure, illiquid type of investment? It comes down to returns. In a survey from BNY Mellon, 96% of respondents said private debt had performed at or better than their expectations — higher than for any other type of alternative investment. According to Preqin, between June 2013 and June 2017, private debt funds recorded double-digit annualized returns. Direct lending strategies led the charge, returning 13.8%. Between the rising rate environment and equity's volatile 2018 finale, the returns for an uncorrelated asset class like private debt are hard to argue with..
These investments are not for everyone. As Legg Mason points out, alternative investments come with quite diverse returns. Their liquidity can vary greatly as well. But for the right investors who have the desire, capital, and risk profile to look elsewhere, alternatives can provide a great cushion to protect your portfolio and potentially increase your returns. There's a place for traditional investments with every investor, but don't forget to consider the alternatives when building your portfolio. (More: Active vs. passive: The case for both) Aaron Hodari is a managing director at Schechter, a boutique, third-generation wealth advisory and financial services firm located in Birmingham, Mich.
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