Numerous studies evidence the benefits of holding alternative assets as part of a diversified retirement portfolio. When used appropriately, non-traditional assets such as real estate, private equity and hedge funds can improve portfolio diversification, enhance risk-adjusted returns and broaden the set of investment opportunities. Many alternative assets have low correlations with traditional investments, making them effective tools for reducing portfolio volatility. A recent study by investment research firm Robert W. Baird noted that replacing 20% of a traditional stock and bond portfolio with alternative assets cut volatility by 10% while also increasing returns, even after taking into account added fees and expenses.
Some investors mistakenly think about alternative assets as a single asset class, but this can lead to poor choices since each alternative asset is designed with a specific purpose and to deliver a unique set of benefits. The risk/reward trade-off of each must be weighed separately to select a product compatible with the investor’s financial objectives, liquidity requirements and risk tolerance.
Alternative assets employing complex or opaque investment strategies may be poor choices for the average investor. This is an issue with some hedge funds, which employ tools such as forward contracts, swaps, options, derivatives and features that can leave even the most sophisticated of investors confused. An average investor makes a huge leap of faith when buying these products, betting that a smart hedge fund manager will also have a market-beating strategy. The flaws in this thinking were demonstrated by Long-Term Capital Management, a prominent hedge fund from the 1990s managed by two Nobel Prize winners that nonetheless lost billions of dollars for its investors. The odds remain stacked against the average investor. According to Bloomberg, the 20 most profitable hedge funds earned $15 billion in 2015, while the rest of the industry lost $99 billion.
Other drawbacks of hedge funds are ultra-high investment minimums, lengthy lock-out periods and hefty management fees. Hedge funds are known for their 2/20 fee structure; managers typically take 2% annual fees plus 20% of fund profits. This type of fee structure may actually encourage managers to make riskier bets that maximize their fees. Another issue is that hedge funds aren’t subject to the same regulatory scrutiny as other investments. Investors may find it difficult to evaluate the fund’s holdings or performance.
Another alternative asset poorly suited for average investors is private equity, which owns stakes in business turnarounds and start-ups. The primary advantage of private equity is the scope of the opportunity. Privately-held companies make up roughly 95% of the market. A key disadvantage is the relatively short lifespan of these investments. The typical private equity fund lasts just ten years. Another drawback is their limited liquidity. Investors must commit large sums (usually $100,000+) and are usually precluded from withdrawing capital for up to ten years. There is also risk that fund assets are priced inefficiently. Valuing turnarounds and start-ups is an inexact science and investors won’t know if fund assets were valued correctly until years later, when the fund is liquidated and its asset are spun-off or sold.
Real estate remains the most popular alternative asset. Real estate provides low correlation with stocks and bonds, a tangible value and an enormous set of investable opportunities. Direct property ownership isn’t desirable for the average investor, however, due to high transaction costs and property management fees. Properties are costly to operate and require ongoing maintenance.
Because of the transactions costs, few investors can afford to own multiple properties. Owning a single property concentrates risks. The cyclicality of real estate markets can also result in sub-par investment results for multiple years.
While not widely known, mortgage pool funds have characteristics that should appeal to everyday investors. These funds provide portfolio diversification, have simple strategies and deliver income, liquidity, and transparency superior to many other alternative asset classes.
A mortgage pool fund is created from a pool of real estate loans owned collectively by the fund’s investors. Most mortgage pool funds have hundreds of mortgage loans or trust deeds in their portfolio. These loans are diversified geographically and by size and property type. A trust deed is similar to a mortgage, but has the advantage of allowing lenders to foreclose on the property without going through a judicial process. Risk is minimized by holding only first lien trust deeds, which have priority over all other claims on the property.
Unlike complex hedge fund strategies, mortgage pool funds generate income from straightforward fix-and-flip loans. These loans are made to real estate professionals who need funding to acquire, renovate and market properties. Unlike private equity, which can take years to deliver results, the results of a property flip are known within a few months. Most fix-and-flip loans have one to three year terms. Mortgage pool fund are shielded from losses on unsuccessful flips by underwriting criteria that limits loan to 70% or less of property value. If the loan defaults, the mortgage pool fund can recover principal and interest by re-selling the property. Since the property’s value exceeds the loan amount, investors shouldn’t lose money even in a foreclosure.
While direct property ownership often involves considerable time and effort, mortgage pool funds are professionally managed. The role of the investor is to cash distribute checks. Mortgage pool funds are designed to deliver predictable monthly income and most also give investors the option of re-investing distributions into the pool to expand their investment. At present, monthly distributions from the Socotra Fund yield between 7-9%.
The limited liquidity of many alternative assets may pose a problem for average investors, who sometimes need funds for the unexpected or emergencies. Mortgage pool funds address this issue by enabling investors under certain circumstances to redeem all or a portion of their investment at a time of their choosing. Liquidity policies vary across funds and start-up funds often have lock-out provisions in their early years so investors must do their homework first by reading the liquidity policy outlined in the fund’s offering memorandum.
For everyday investors who desire an easy-to-understand asset that deliver reliable income and liquidity, mortgage pool funds are hard to beat. Investors can learn more about the Socotra Fund by visiting the Socotra Capital website.