The phrase “alternative investments” is typically used to describe any unconventional investment that is not considered a stock, bond or cash. This very broad definition has led to a wide variety of asset types ranging from publicly traded real estate investment trusts (REITs) to private rare wine collections all being lumped together in one catch-all category. For most investors, alternative assets include private REITs and business development companies (BDCs), but there are alternatives to these traditional alternatives that can offer significantly more diversification benefits.
With stocks trading at historically high valuation multiples and bonds offering very little in terms of yield, more investors are turning to more exotic alternative investments to supplement their stock/bond/cash portfolios. But not all alternative investments are created equal, nor do they offer the same level of benefits to a traditional portfolio. There are two questions investors should ask themselves when considering an alternative investment. First, does it offer adequate return for the level of risk? Second, does it reduce portfolio-level risk by adding meaningful diversification?
Traditional alternatives have a mixed history of performance and have offered little in terms of true diversification benefit. Thankfully, the universe of alternative investments is much broader than just private real estate and BDCs, but more does not always equate to better. Investors should consider the following to differentiate between alternatives that should and should not be considered for investment:
- Are there fundamental return drivers, such as capacity constraints or regulatory changes, to support the projected returns?
- If the alternative investment is private, are investors being adequately compensated for the extra illiquidity risk compared to a more liquid proxy?
- Are the risk factors of the underlying investment significantly different than those already expressed in the existing portfolio?
Alternative investments that check all three boxes have a better chance of achieving their dual objective and should be considered for investment. Although in no way exhaustive, the following are some examples of nontraditional alternatives that might make the cut.
LITIGATION FINANCE
Law firms frequently need capital to manage cash flow, develop cases and grow their business. Since the passing of the Dodd-Frank Act, banks have been less willing to make nontraditional loans that are not collateralized by tangible assets such as real estate. By and large, law firms are good borrowers that are light on hard assets, but have plenty of intangible assets, such as their attorneys and their contingency case docket. The lack of tangible hard assets has made it difficult to source traditional bank loans in the new regulatory environment.
Private capital has filled the void by underwriting the docket of contingency cases to either purchase a profit’s interest (equity) or extend a loan (debt) against them as nontraditional collateral. This type of investment can be risky due to the binary nature (win or lose) of a case, but conservative underwriting and diversifying across many cases goes a long way toward overcoming this issue. The counter-cyclical nature of this industry offers compelling returns with excellent diversification benefits.
LIFE SETTLEMENTS
Life insurance is a useful tool for crafting a robust financial plan. Unfortunately, the sad truth is that roughly nine out of 10 universal life insurance policies never payout a death benefit because they are either surrendered or lapse. The most common reason people forgo their policies is financial hardship and, up until recently, the insured has been left with only one option of dealing exclusively with the insurance carrier in this instance. The life settlement industry was created to give the insured more choice by offering to purchase policies from individuals who no longer want or can no longer afford to service their policies.
Life settlement transactions create a win-win for both the insured and the investor. The insured receives on average four times more than when surrendering the policy back to the insurance carrier, and the investor receives an asset that, if underwritten properly, should generate compelling returns with no structural correlation to the common risks underlying stocks or bonds in a traditional portfolio. The biggest risk in life settlement investments is extension or longevity risk, which is why it is important to build out a portfolio of policies so that underwritten returns can be modeled using a normal bell-shaped distribution.
INFRASTRUCTURE
Infrastructure investing is a broad category that includes physical assets we use in our everyday lives, such as bridges, roads, pipelines, etc. These types of assets are noncyclical, have high fixed cost but very low marginal costs, and generate steady cash flows. Infrastructure investments are more defensive in nature due to the stability and predictability of their cash flow streams, but they also provide plenty of growth opportunity because of their low marginal cost structure. Any additional revenue that can be added to the asset flows almost entirely to the bottom line which improves the cash flow and makes the asset more valuable. These aspects make infrastructure investments highly appealing to institutional investors. Their appetite creates an opportunity for smaller, more nimble investors to acquire individual assets and roll them up into a portfolio to be sold to institutional investors who are willing to pay an aggregation premium for the larger, single transaction.
Two industries to highlight within the infrastructure space that are delivering significant aggregation premiums due to their structural tailwinds are renewable energy and wireless infrastructure. The cost of utility-grade solar and wind generation has declined significantly over the past decade and is now cost competitive with traditional fossil fuels. Coupling this and widespread adoption of renewable energy mandates by state and local governments has created multi-decade, noncyclical demand for this industry. Wireless infrastructure is enjoying a similar tailwind with the recent rollout of new 5G technology, which is creating a tremendous amount of demand for in-filled wireless infrastructure due to the shorter wavelengths of the new technology.
CRYPTOCURRENCY
Cryptocurrency has grown from being a niche, speculative market to widespread global adoption over the past several years. The market is wide open like the wild west of yesteryear, which has led to massive amounts of innovation, speculation and outright fraud. As such, there is tremendous opportunity for investors who can successfully vet and navigate the space. The crypto universe is continuously evolving, but presently there are three different primary types of investment in the space: holding crypto coins, venture funding into new applications being developed on an existing blockchain protocol, and short-term lending.
The first two categories are high-risk, high-reward strategies, while the latter has lower return potential but a better risk/reward tradeoff. When structured properly, short-term lending into the crypto market can generate impressive returns while providing downside protection using digital wallets, stable coins and real-time collateral controls. This strategy can complement not only the volatile, asymmetric strategies in the crypto space but also a more traditional portfolio due to its unique risk characteristics. Not all lending strategies are created equal, so it is important to understand exactly how returns are being generated and what risks are being taken.
MEDIA AND ENTERTAINMENT
The media and entertainment industry encompasses a wide variety of investment opportunities ranging from secured lending to venture investments. The changing regulatory environment has pushed most traditional financiers out of this space, which has created an opportunity for private capital to structure very favorable terms. The risk profile and cyclicality of these types of investments vary greatly, but if structured properly, there is an opportunity to generate great returns due to the bifurcated nature of this highly relational niche industry.
Two investment strategies in this industry on the lower end of the risk and cyclicality spectrum would be rights, royalties or revenue shares on digital media such as music, books, video games or online content and secured film/TV production loans. Revenue from a seasoned catalog of digital media assets generates a highly predictable revenue stream that is noncyclical in nature as the economic barrier to entry for the consumer has been lowered with the widespread adoption of monthly subscription services. Secured production loans are typically backed by nontraditional collateral in the form of tax credits and prepaid distribution rights. The economics of a secured production loan have little to do with the success of the film or TV show being produced and more to do with the investor’s ability to structure the loan and navigate the complex tax credit landscape.
CARBON CREDITS
In 2013, California established a carbon cap-and-trade program, which was modeled after the European market with the goal of dramatically reducing greenhouse gas emissions over the following several decades. Gross emitters such as power and industrial plants along with fuel distributors are required to procure allowances in the same amount of their annual carbon dioxide emissions. Allowances are allocated freely by the state, auctioned off quarterly, and trade between counterparties in the open market.
Since their inception and by design, the supply of California Carbon Allowances (CCAs) has outpaced demand to give greenhouse gas-producing industries plenty of runway to mitigate their emissions. The price of CCAs have hovered around the established floor value, which increases by CPI plus 5 percent every year due to this oversupply, but that could soon change as many expect the supply/demand imbalance to flip very soon. When this inflection point occurred in the European market, the price of the credits increased rapidly as emitters were forced to purchase credits in the open market at prices that were still well below their marginal cost of mitigation. Due to this setup, CCAs offer investors asymmetric upside potential with limited downside.
The goal of every financial adviser is to grow their clients’ assets in the most risk efficient way possible to meet their objectives. History has shown the best way to do this over long periods of time is through a well-constructed portfolio of diversified assets. The famous economist and Nobel Prize winner Harry Markowitz once said that “diversification is the only free lunch in investing” because it can reduce risk without sacrificing returns. In today’s interconnected world, finding investments with unique risk characteristics that offer real diversification benefits is difficult to say the least, but is why alternative investments can play such a vital role in a portfolio.
It is vital to understand the underlying risk factors of an alternative investment to determine whether it is providing true diversification or simply making more of the same bets already expressed in the portfolio. Each alternative investment must be thoroughly analyzed to understand the sources of risk and return, but for those willing to put in the work, true alternatives can offer not only compelling returns but meaningful diversification benefits to client portfolios.
Elliott Orsillo is principal and CIO at Season Investments.