How do alternative investments help us invest?
“Jackalope” Postcard from 1968. Source: Legends of America
The purpose of investing is help us reach our financial goals. The disclosures tell us that “all investments carry risk,” and that’s true. We diversify our portfolios to reduce that risk. Alternatives are necessary today because ultra-low interest rates have reduced the utility of bonds for risk-reduction. It doesn’t matter how well an investment worked the past, what matters is how it works looking forward. You can’t drive where you need to go if you just look in the rear view mirror!
Here’s a list of alternative investments I’ve compiled, with their corresponding seniority, and an estimate of their liquidity and complexity.
All economic assets depend on the economy. A huge pile of gold is worthless if it’s stranded on Mars. Alternatives are just different ways to tap into the economy’s wealth. Each one of these alternatives had different levels of seniority (or economic security) different levels of complexity, and different levels of liquidity – how long it would take and investor to get their money out.
At the top of the list are insurance products. Most people are familiar with them; they are among the oldest financial products. These are policies written by a life insurance company. Insurance can be a problematic area for investors, because insurance products have often been sold with significant commission structures. Those commissions can shape the kind of policies and products that are sold. The fine print and disclosures can be mind-numbing.
Source: NY Fed
Nevertheless, annuities that pay out an income stream (until we die, that’s why they’re sold by life insurance companies) are a good hedge against outliving our assets. They’re also a natural hedge for the insurance company – the insurance company makes more money when an annuitant dies early but loses money when a life insurance policyholder dies early.
Settlements are a way for outside investors to hold insurance policies. They pay the premium for someone giving up an unneeded policy and pay a lump sum to the insured person for that privilege. Then they collect the insurance proceeds at the end of the period.
Insurance products are policies; they have moderate liquidity and they’re highly complex. As anyone who’s ever had second thoughts about an annuity has learned, it’s easy to put your money into one, but there can be a lot of red tape in getting your cash out.
Options products, by contrast, are highly liquid. Options are either traded on an exchange or over-the-counter with a major financial intermediary. These companies make markets in options; it’s their primary job. But options are complex, priced according to the Black-Sholes model.
The pricing may be challenging, but the concept is simple. Options give their holders the right, but not the obligation, to buy or sell a product at a specific price at a specific time. This “right but not obligation” means that owning options can help us various manage risks. It also means, however, that options get more expensive when markets get more risky. They’re like a hardware store selling generators in Florida during hurricane season.
Photo: NASA. Source: Wikipedia
Legal assets are investments in royalties, litigation, and other intellectual property. The contracts need to be scrutinized by your own legal counsel, but they can be lucrative, long-term assets. They come to market because the owners of this intellectual property might not want to wait to receive their cash flow. For example, the estate of John Lennon receives a royalty payment every time “Imagine” or “Let it be” is played on the radio or in the movies. If his estate wants to, it can sell the right to some of all of this future cash flow. Litigation rights are slightly different. Sometimes people with a claim can’t afford to pursue it in court. A litigation investor pays for the legal challenge in exchange for some of the proceeds if the case is successful.
These payment streams function and are priced like bonds – with a price determined by the present value of future cash flows. But they depend primarily on the legal system. They are often uncorrelated with the economy.
By contrast, investing in real assets gives us rights to the product of the land, whether it’s farmland or timberland or solar/wind “farms” or mineral rights. The more the land produces and the higher the price, the greater the investor’s return. That’s why these rights are more like real estate. They tend to be good hedges against inflation, but they suffer during a recession – and especially during a depression.
Public Domain. Source: Wikipedia
Direct lending, hedge funds, private equity, and commodities traders are a different breed of alternatives. They aren’t really a different type of asset, they’re a different type of fee structure. Direct lending is pretty straightforward, but hedge funds and private equity are different. They have high management fees, and they also take a share of a portfolio’s gains. Hedge fund managers are also free to invest in all kinds of things, to concentrate their portfolios, to use leverage, to short different assets, and so on. The increased incentives and greater flexibility should improve performance. But sometimes, hedge funds run out of ideas. Then they end up doing silly things, like putting most of their money into one stock.
In the long run, these management alternatives depend on the stock market for many of their activities, whether it’s IPOs to get cash out of a startup, or market multiples to figure what the value of a company might be in a mezzanine-funding round. It’s no surprise that correlations are pretty high, even if their performance may be better.
Photo Quicksandala. Source: Morguefile
The most important aspect of alternative investing is to do your homework. Alternatives carry great potential, but because each type of alternative is different, there is a lot of potential for abuse. Different fee structures can create perverse incentives that aren’t always in the clients’ best interest. And many alternatives managers have creative ideas about their fiduciary duties.
The current investment climate requires us to consider alternatives. Every product has its own risk – and it’s own return. Just be sure you understand how each product fits into your specific portfolio – and your total financial profile.
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