Alternatives in Focus – Q2 Newsletter

We’ve been getting a lot of questions about our alternative investments recently, so we thought we would introduce a new, at least quasi-regular, column in our newsletter  focusing on this asset class. We’ll talk this time about  why we  use alternative investments, but in the future, we’ll do a deeper review of some of the funds.

Historically, a mix of stocks and bonds was sufficient to meet most investors’ return needs. Stocks provided long- term growth, and bonds moderated risk. Though, in the past, even bonds were able to deliver decent returns. From the 1920s forward, bonds have provided average annual returns of 5.5%. A diversified mix of stocks has delivered annualized returns of almost 11% over the same period.

The basic rule of thumb in financial planning literature is that you can draw 4% per year from your portfolio for your living expenses.  This would keep your purchasing power in tact over the long run, so your portfolio would always be there to provide for your needs. Using this concept, and if we do a little math, we can back into a required investment return. If you are drawing 4% from the portfolio, and paying roughly 1% in total fees (industry wide, most investors pay far more than this), and factor in 3% for inflation, then you need an annualized return of 8% over time. That’s a pretty high hurdle, but traditional balanced stock and bond portfolios have been able to approximate that return over time.

Today, the scenario is different. Safer bonds are yielding 2.0 to 2.5%. Stock valuations are fairly high compared with historic norms, so it is unlikely they will deliver the same sorts of returns we have enjoyed in the past. Accordingly, many studies conclude that investors will need to settle for lower returns, which means they should draw less from their portfolios and spend less on living expenses. That can result in some uncomfortable life choices, particularly for retirees.

We believe there is another  way, and that includes the addition of alternative investments. These  are not for everyone, but they do have the potential to add incremental, long- term returns without adding undue risk.

The term “alternative investments” typically means hedge funds or private equity. These types of investments are often illiquid, expensive, unregulated, and offer little transparency with respect to their investment approaches. Alternatives don’t have to be hedge funds though. We have found asset classes and strategies that offer unique return characteristics, but with better terms than those offered by most hedge funds.

The alternative investments we use include catastrophe bonds; private lending; market insurance; private real estate; and strategies that involve options, futures, and other more esoteric investments.

Like hedge funds, the alternative investments that we employ are also more expensive than stock market index funds. They  also  are  often not tax efficient, and sometimes they aren’t as liquid as regular mutual funds. However, if costs are managed, and the net returns are high enough, we still think alternative investments can make sense.

Incorporating investments beyond stocks and bonds is a strategy that rs. Over the last decade or so, innovation in the financial industry has brought new mutual funds and exchange- traded funds to market in a more democratized fashion. Individual investors can now participate in asset has been used in the institutional investment world for many years. In the past, these types of investments have required very large dollar amounts, and were not generally accessible to individual investo classes that only a few years ago were unthinkable.

There will certainly be ups and downs with alternative investments. Some funds will thrive and others will falter at various times. However, that is the nature of a diversified portfolio. If returns are truly independent and uncorrelated among the assets in a portfolio, there will be winners and losers at any point in time. That doesn’t mean we sell the losers. This is a long-term strategy,  similar  to the way we manage stock and bond portfolios.

These funds certainly are not perfect, but we believe the inclusion of these types of investments gives investors a fighting chance of meeting their return objectives over time.

This column will continue to focus on alternative investment themes, but please feel free to reach out to us anytime if you would like to discuss these investments, and how they may work for your portfolio, in greater depth.

To Download the complete 2017 Q1 Newsletter please click below.