At the depths of the 2008 financial crisis, few would have predicted that we’d soon enter one of the longest-lasting stock market rallies of the modern era. The current bull market, in which stock prices have risen without a 20% pullback, is now more than eight years old, the second-longest such stretch on record.
And for much of that time, the central bank’s monetary stimulus policies have also led to impressive gains in bond prices (while yields have steadily fallen).
But bond yields have backed up over the past year, and the Federal Reserve has plans for further interest rate hikes in coming quarters, which means one leg of the stocks-and-bonds rally has come to an end. And this spring’s Washington-induced stock market volatility could signal headwinds ahead for equities as well.
The best plan of action: diversification. And alternative investments will play two crucial roles in portfolio management. They tend to be non-correlated with stocks and bonds, which means they can smooth out returns. And certain kinds can produce robust income streams at a time that the bond yields on offer are still small. The key question comes down to whether you want the freedom that highly liquid investments bring, or the potentially higher returns and yields that illiquid investments can often offer.
The Liquidity Trap
One type of investment growing in popularity is interval funds. These closed-end products buy high-yielding, low-liquidity investments such as private loans, structured credit, farmland, “catastrophe bonds” or commercial real estate debt—things often owned by private equity and hedge funds. They don’t carry the high minimum investment thresholds that hedge funds do, but they can be redeemed only once per quarter, typically. That constraint, however, is why they are priced to offer fairly robust yields—they side-skirt the “the liquidity premium” of more readily tradeable investments.
Morningstar notes that there are now around 30 interval funds managing around $9 billion in assets, and another 20 funds are in registration.
One example is the PIMCO Flexible Credit Income Fund (PFLEX). The firm says the interval fund approach allows its bond managers to buy debt instruments that would be ill-suited to a more active trading vehicle. Another fund is the Resource Credit Income Fund (RCIAX), which currently yields around 6.6% with very little default or interest rate risk.
Another illiquid option: health-care royalty funds. These acquire the future revenue streams of small drug firms, either public or private, in exchange for up-front capital that doesn’t dilute current shareholders. Royalty funds can yield 15% or more in annual cash flow, net of fees. However, they are typically available only to accredited investors who have either $1 million in investable assets or who brought in $200,000 in income over the previous two years.
HealthCare Royalty Partners and OrbiMed are leading players in this segment, although other firms are planning to move in.
Lastly, investors willing to tolerate a lack of liquidity may want to consider catastrophe bonds, which provide backup insurance to insurers. Stone Ridge Asset Management is the largest “cat bond” placement firm focused on the registered advisor market, with roughly $4.5 billion in assets under management. Cat bond funds typically offer 8% to 10% yields, net of fees, which is very impressive given their low levels of risk, and they boast diverse types of coverage for disasters in different regions.
Better And More Liquid Than A Hedge Fund?
Institutional investors have long sought protection against slumping markets, typically by investing in hedge funds. Such funds adopt distinct approaches, including market neutral, long/short, global macro, event driven and multi-strategy funds.
Yet these funds have some clear drawbacks, including high fees. They also allow less access to non-institutional investors, and they lack liquidity. Still, two types of fund are worth considering: Liquid alternative investments and infrastructure funds. Both provide portfolio diversification while the latter is also known for robust income streams.
To be sure, “liquid alts,” as the hedge-fund style mutual funds are classified, have suffered from an epic level of bad timing.
Liquid alts came into vogue after the market rout of 2008 and early 2009, since they had enjoyed impressive performance in previous periods of market instability, such as those in 1998 and 2000.
Thus, more than 350 liquid alt funds were launched from 2011 to 2015. But the vast majority generated weak or even negative returns amid surging stock and bond markets.
Longer-term performance is more impressive. According to Hedge Fund Research Inc. (HFRI), stocks rose an average 7.59% annually for the 20-year period ended April. Alternative investments posted a 6.95% yearly gain in that time. Considering how massively stocks outperformed alts in the final five years of that analysis, it becomes apparent that alternative investments fared quite well in the prior 15 years.
So the timing for a shift into liquid alts may be at hand. Their role became more obvious again in 2016, when on three occasions the S&P 500 fell more than 3%. In those periods, liquid alt funds outperformed the index by an average of 460 basis points, said Goldman Sachs Asset Management’s LAI Multistrategy Peer Group.
The challenge for the fund industry is to help investors learn more about the benefits of alternatives. Bill Kelly, the CEO of the Chartered Alternative Investment Analyst Association (CAIA), says his firm has been working with a growing roster of advisors and brokerages that are enrolling in the CAIA’s various courses of study on the subject.
Different Flavors
Various kinds of liquid alts funds can each play a specific role. Global macro funds, for example, “can work well when you have heightened currency volatility,” says Nadia Papagiannis, the director of alternative investment strategies at GSAM’s Global Third Party Distribution. Long/short and market neutral funds, meanwhile, tend to shine when markets and sectors have low correlation.
Of the 647 liquid alts funds tracked by Morningstar (at the end of 2016), “multi-alternative,” which adopts two or more strategies, is the most popular category, with 140 funds on offer. AQR Capital Management has been a top performer, with five of its funds gaining Morningstar’s “Bronze” or “Silver” ratings.
AQR uses academic research to focus on assets that perform well with a low correlation to stocks and bonds. The firm’s AQR Style Premia Alternative Fund (QSPIX), for example, looks at the value, momentum, carrying costs and defensive characteristics of all alternative assets, and adjusts its portfolio according to market conditions. Since it was launched in October 2013, the fund has returned around 6% per year, which lags equities but surpasses the vast majority of liquid alt funds.
But it’s worth noting that most liquid alt fund fees tend to fall on the high side of the industry average, and this fund has an 1.60% annual expense ratio.
This was one reason Adam Patti founded IndexIQ, to deliver liquid alt exposure in an ETF format. “We wanted to provide the benefits of alternative exposure in a lower cost and tax-efficient way,” he says. The IQ Hedge Multi-Strategy Tracker ETF (QAI), which has a 0.96% expense ratio and $1.1 billion in assets, has generated positive returns in six of the seven years it has been in existence.
Patti, whose firm is now owned by New York Life, says that demand has been strong in the past year for the IQ Merger Arbitrage ETF (MNA), which carries a 0.77% expense ratio. “The big advantage with this fund, compared to the hedge funds that focus on M&A, is that the ETF is very tax-efficient with little or no capital gains.”
Infrastructure in Focus
For those in search of portfolio diversification, hard assets or real assets may be appealing. These include infrastructure assets such as roads, ports, bridges and electrical grids, and also good old-fashioned real estate.
“These kinds of assets seemed a bit boring a decade ago on a relative basis,” says Anne Valentine Andrews, the chief operating officer for the BlackRock Real Assets platform. “But they are really resonating with investors given the benefits of portfolio diversification and regular yield.”
As interest in infrastructure assets rises, there is a growing set of funding needs. “Governments don’t have enough capital to maintain or build infrastructure on their own, and private capital is helping to fill that gap,” notes Andrews.
Ben Morton, a portfolio manager for Cohen & Steers’ infrastructure portfolios, agrees. “We’ve seen a great deal of privatizations and capital formation in the infrastructure space. There have been a growing number of listed infrastructure opportunities in recent years.” Cohen & Steers offers a pair of infrastructure funds, a closed-end fund (UTF) and an open-end fund (CSUIX).
The Lazard Global Listed Infrastructure Portfolio fund (GLIFX) garners five stars and a Bronze rating from Morningstar. The fund, which carries a 0.95% expense ratio, focuses on what Lazard calls “preferred infrastructure”—firms that have a monopoly-like grip in their markets, heavily regulated markets that have pricing power thanks to inflation indexing.
The Nuveen Real Asset Growth and Income Fund (DRA), which invests in infrastructure and real estate, generates a distribution yield of 7% to 8%. The underlying yields of the holdings in the portfolio are not quite as robust. To boost yields, Nuveen’s fund managers write covered calls against some of the holdings, which produces additional income streams.
Liquid or not, there are ample ways to lighten your exposure to the traditional stock and bond axes. Each of those asset classes brings its own set of risks these days, from valuations to central bank policies. So an effort to reduce risk through these alternatives may prove to be quite timely.
