Are your alternative investments truly alternative?
Retail investors should understand the risks and opportunities of investing in alternatives.
Once upon a time, alternative investments (e.g. private real estate, private debt, private equity, infrastructure, etc.) were the exclusive domain of pension funds, billionaires and sophisticated investors. After all, it takes size, scale and specialized expertise to access this unique breed of opportunities – something we’ve worked hard to successfully cultivate at Newport over the past fifteen years.
Today, however, alternative investments have gone ‘mainstream’ as investment firms seek to capitalize on retail investors’ appetite for their diversifying effects. Because of their low correlation to traditional investments (i.e. stocks and bonds), alternatives can moderate volatility, enhance return and help investors stay the course.
As a result, there’s been a proliferation of offerings, including some from traditional mutual fund companies. While we are encouraged to see the democratization of alternative investments, we are also concerned about the quality of some products and the fact that investors may not be fully aware of the features and risks of what they own.
This blog post identifies the questions to ask and the risk factors to consider, along with the ways we view and reduce risk when investing in alternatives.
Consider how much is appropriate for your portfolio
One of the biggest risks we see with individual investors is an over-commitment to alternative investments. These are meant to complement not replace traditional investments as part of a well-balanced strategy. Be careful not to overweight.
How diversified are your alternative investments?
Unless you are dealing with a money manager skilled in alternative investments, it can be a challenge to obtain the same level of diversification that you would expect of your traditional investments. Make sure you know what you are invested in and how diversified it is. We diversify multiple ways: One, by asset type – apartment buildings, private debt in mid-market companies, infrastructure projects, etc. Two, by project – no one or two investments would have a meaningful impact on returns. Three, by geography – Canada, U.S., Europe, etc. and, finally, by specialist manager – having several in our stable and not hitching our wagon to one or two.
Are they truly alternative?
Some products billed as alternative investments are made up of publicly-traded securities – Real Estate Investment Trusts (REITs) being a good example. While REITs are portfolios of real estate properties, REITs trade on a stock exchange and are therefore subject to the daily pricing fluctuations and equity market volatility most investors are seeking to mitigate with their alternative strategy. If you own a fund or portfolio that claims to be alternative, make sure you understand the underlying capital market exposure.
What is the liquidity risk?
By contrast, investing directly in private alternatives will present liquidity risk. Unlike publicly-traded securities, these types of investments can’t quickly or easily be converted to cash. This can present a challenge for investors – another reason to be cautious about how much you allocate to alternatives. Be sure you understand what the liquidity constraints are, if any, before you invest.
We provide liquidity in a variety of ways: One, by having a large and well diversified portfolio of private alternative assets, we have multiple sources of cash flow as most generate income. Two, we complement our alternative investments with select publicly-traded securities that have liquidity. Three, we maintain cash reserves in each of our funds.
Large, well-capitalized projects mitigate risk
Investors sometimes get into trouble by investing in smaller, early-stage deals that promise a yield that is not supported by the underlying asset. If you’re being sold an earlier stage opportunity, dig into the numbers to satisfy yourself the targeted rate of return merits the risk.
We reduce risk by focusing on large, mature, well-capitalized opportunities where the capital structure is aligned with the return profile.
Is there cash flow?
Most of our alternative investments produce cash flow through rental income, lease payments, dividends, etc. On rare occasions when we invest in a development deal, we buy with cash and do not take on leverage until the property is leased out or sold.
What is the track record of the management team?
People risk is always a factor. We will only invest with management teams that have depth and expertise in their sector. Risk is also reduced when the manager has significant amounts of their own capital at risk. Don’t be too shy to enquire about how much of the manager’s own money is at stake.
Is the manager’s fee structure aligned and fair?
Do you fully understand the fee structure for the investment you are making? You can expect higher management fees for alternative assets as they are harder to access and have unique investment qualities. At the same time, the fee structure should be fair and aligned. We have turned down many otherwise attractive opportunities based solely on their fee structure.
While there are some unique features to investing in alternatives, the basic principle remains: understand what you own and why.