Are Alternative Asset Classes the Cure for Pandemic Boredom?
It has now been one full year of pandemic life. Over the past twelve months, COVID has dealt us some of our greatest struggles and sorrows, but has also shown us the power of community, the hope of innovation, and the value of human connection and love. Our emotions have been pulled to extreme highs and lows; our nerves have been rattled by a life upended. And yet, in spite of the chaos, most of us have found ourselves bored. Not just a few of us, and not just a little bored either - more than half of people in the US are more bored than they were before the pandemic, and most of them are using purchases and investments to cope. Pandemic boredom is literally repositioning the economy. We’ve already written about the Gamestop spike and active investing, which has been one side effect of this shift. Today, I’m addressing another “boredom finance” fascination: alternative asset classes.
Alternative asset classes (a.k.a. alternative investments, alternatives, alts...) is a broad term for investments other than stocks, bonds and cash. Alternatives have traditionally included hedge funds, private equity, real estate and commodities, and were limited to investment by institutions, due to high asset minimums, limited liquidity and restrictions set forth by financial regulators. In today’s world, where pandemic boredom is driving people to spend in novel ways, faith in traditional markets have been put into question (looking at you, crypto & NFTs!), and interest rates have reached all-time lows (anyone thinking about buying a rental or investment property?), talk of alternatives is growing popular in mainstream discourse.
Having spent my pre-Mana career in the hedge fund industry, I (Stephanie) am certainly no stranger to alternative investments. I do believe that alternatives have an important place in a portfolio. They work nicely as a complement to an overall asset allocation of traditional asset classes. To illustrate my thinking on alternatives to our readers, I really want to dive into the basics. In the rest of this post, I’ll talk through some examples of alternative investments to demonstrate why risk management is so important, and give you some useful insights on how you can incorporate alternatives into your investment portfolio along the way.
To get started, it’s important to understand what an asset class actually is. Technically speaking, an asset class is a type of investment, appropriately specified if:
Assets in a class have similar traits and stats
Classes are not highly correlated
Individual assets cannot fit more than one class
Classes cover the majority of investable assets.
Classes contain sufficient liquid assets.
Let’s walk through traditional asset classes - stocks & bonds. The table below shows how stocks and bonds are captured with these five criteria.
The goal of assets is either to generate positive yield or growth. Yield can be thought of as cash flow, and growth can be thought of as increase in value. It’s important to distinguish between these two outcomes when considering any investment, because your management strategy and risk assessment should vary depending on your goal type.
While investing in traditional asset classes can be complicated, it still requires a far simpler strategy than venturing into the alternative investment space. Stocks, bonds and cash have a deep and well documented history, giving us great insight into how they perform during various market environments. We can clearly define our goals in these spaces. Even more importantly, we can somewhat understand and analyze these markets by reflecting back on critical scenarios where interest rates rise, inflation picks up, when currency is devalued, or when government regulations and policy are driving change. Although the past does not predict the future, the transparency and history of these markets provides investment advisors with an understanding of the general risks and return potential. That is to say, you can’t beat the market, but you can definitely identify a significant portion of the risk within a portfolio and time horizon, and plan accordingly.
Nevertheless, many people do not want to stay totally traditional with their investment strategy. In recent years, the democratization of alternative investments has become a reality. Investment apps like FundRise, YieldStreet, Artivest, or Coinbase give individuals the ability to generate yield or otherwise high returns by investing in real estate, asset backed securities, and cryptocurrencies. To some degree, this is a positive, because we would love for everyone to be able to participate in investing, and to have access to the same sorts of opportunities as institutional investors. However, we also want to emphasize that the risks are not broadly advertised as part of these investment offerings. We want our readers to understand that if you are an individual who isn’t partnered with a financial planner who is experienced in this space, you may not fully understand the risk, and you certainly won’t have an expert team managing your exposure.
Alternative investments have inherent complexity and risk due to their lack of transparency and liquidity. There isn’t an exchange that securities are freely traded on, and oftentimes it can be difficult to discern who your counterparty is, or where your money or asset is physically being stored. Moreover, when markets go awry (or even when they don’t!), you may not be able to sell your investment and get your money back. Because of these complexities, it’s important to know that there are a lot of behind the scenes deals being struck to move money.
One fairly accessible way to explain the intricacies of alternative investment risk is through the auto loan market. I like using this example because we’re all familiar with the idea of getting a loan to buy a car. However, something that I am intimately aware of - but you may not realize - is that your auto loans are oftentimes sold to hedge funds. Hedge funds seek assets with high return potential, and they spend lots of money on highly educated research teams who are tasked with the goal of finding and investing in assets that generate the highest risk adjusted returns. In 2014, as a result of this type of research and prospecting, several hedge funds decided to start buying auto loans from banks who were unable to hold them due to restrictions put into place during the Global Financial Crisis of 2008. These loans were generating a reasonable yield in a market where yield was hard to find. In 2014, the economy was on the rebound, consumers were considered financially healthy, and their loans were being paid. However by 2016, after oil prices crashed, many parts of the US were suffering from unemployment. The market shifted, and unpaid subprime car loans hit a 20 year high. What this meant is that the returns predicted by hedge funds who bought these auto loans were not achieved. These returns were neither achieved from a yield perspective, nor from a growth perspective. Auto loans are 3-5 year assets with little-to-no liquidity, and many hedge funds were forced to write off these investments - resulting in massive (and sometimes complete) financial loss. The moral of the story here: if your investment promises high yield, you should expect high risk. The biggest risk in high-yielding assets is that they can default, which means you won’t generate a yield, and you may lose some, or all, of your initial investment. While I can’t say that we’ve been receiving too many calls about the auto loan market at Mana (outside of individuals who want to buy a car), the example above does illustrate how market factors that are far-removed from the actual investment asset can massively and negatively impact the investment outcome. This idea is a slippery slope - even in a space as benign-presenting as auto loans, there can be many hidden stakeholders and risk factors at play. For newer alternatives, even finance experts may not have a clear understanding or knowledge of the risk factors or stakeholders that are driving valuation. In some ways, this is an exciting premise - we’re watching history get made and economic patterns become established in real time with things like NFTs and cryptocurrencies.
Which brings us to our next point...
Recently we are hearing quite a bit from our clients about two alternative asset classes in particular: 1) Rental Real Estate, and 2) Cryptocurrencies.
Rental real estate has the ability to make you a significant sum of money over a long period of time. The US has provided great tax benefits for real estate investors, meaning that you can earn money in a much more tax-efficient manner than you might in a traditional asset class. However, housing’s yield and growth potential does come with significant risks, including a lack of liquidity, the cost of property tax, maintenance and upkeep/renovations/improvements, and the potential for tax policy shifts or interest rate changes. We’ve elaborated on these and other decision points around homeownership in previous posts.
At Mana, we rarely consider rental real estate investment as a viable option for yield (cash flow). Rental properties are not a good choice for passive income. While buyers are typically somewhat aware of maintenance costs and tax implications, many do not consider some of the more nuanced risk associated with rental properties, like local zoning and legislation around renter protection. If you live in a tenant-friendly state (hello California!), you should have one year of mortgage expenses saved in an emergency fund at all times. There are many scenarios where you should expect to have to cover these costs for extended periods of time - in other words, you shouldn’t consider this investment a free mortgage payment. Rental real estate is best thought of as a long-term speculative investment with a smaller downside than something like individual stocks. The growth potential is often worth it, but only if you have immediate financial stability and resources to maintain your property ownership over a long period of time. Appreciation is not guaranteed!
Photo from Aleksi Räisä (https://unsplash.com/photos/y-BIhyjjHv4)
Cryptocurrencies are digital currencies, handled through a decentralized technology called Blockchain, that can be exchanged for various services and goods. The most popular cryptocurrency, called Bitcoin, has become wildly popular and quite valuable in recent months and years. The technological security and decentralization of cryptocurrencies are what drew the majority of its early appeal. However, these days, the speculative nature of its value (specifically, the fact that its value has been rising) generates a considerable amount of interest from the public. Currently, the value of cryptocurrencies is completely dictated by the ability for it to be sold at a higher value. Cryptocurrencies are not able to generate substantial yield, or cash flow (though they can be mined). This is a considerable risk, and the historical value of cryptocurrencies has been wildly volatile. Cryptocurrency prospecting creates an interesting problem of individuals holding their Bitcoin today with the expectation that they will be worth much more in a number of months or years. However, because the value of Bitcoin is dependent on its circulation, it is not clear whether holding it is actually a good choice. We like to draw an analogy between gold and cryptocurrency, in that they are both limited resources with investment prices dictated by supply, demand, and investor culture and behavior. There is a lot more to understanding cryptocurrencies, and our current view at Mana is that they are an interesting alternative asset class, but should not be incorporated as a core component of your investment strategy.
Before we sum things up, if you’re considering alternatives in your portfolio, our best advice is that you start first by examining the goals you have in life. We also encourage you to ask yourself the following four questions:
What are the fine details of this asset’s return speculation? Am I investing in it because “everyone else is”, or because I understand these details intimately?
Do I understand a significant portion of the risk involved? Does anyone understand the full risk?
Can I afford to lose my entire investment?
Have I discussed my plan with a financial advisor?
It is absolutely critical to align your investments with your goals. There is no “get rich quick” strategy that does not come with extreme risk. It’s true that many of us would like to be super-rich, but it’s also true that all of us want to be at least financially secure and personally fulfilled. Never allow a high-risk investment to compromise your basic needs and financial security. Alternative investments can serve an important place in your portfolio, providing you with an asset that has positive returns, and low correlation to your traditional investments in stock, bonds and cash. But these alternatives should be chosen carefully, to provide you with diversified growth so that your overall portfolio can withstand various market environments with greater stability. Alternatives often have higher volatility, longer down cycles, less transparency, higher complexity, and lower liquidity. The combination of these factors necessitates much more up-front research before you commit, and requires substantially more time and focus to monitor.
The amount of money you can safely put into alternatives really depends on your financial situation, but our recommendation (if you do decide to invest in them) is to recognize that this is money you can lose. Having spent a great deal of time becoming an expert in alternative investments, I have seen their failures arrive in so many different ways, which makes me increasingly cautious of how much is invested into something that is not easily understandable, and lacks predictability or clear analysis. Discerning risk from return potential is the most essential part of investing into alternatives: they are far more similar to a blackjack bet than a 401k. That being said, in a pandemic where many people have found themselves with excess wealth and unused time, exploring alternative asset classes could be a perfect casino thrill to break up the monotony! Although they can be fun and engaging, we urge our readers to consider these investments carefully. After all, there are plenty of reliable ways to grow wealth at a reasonable pace, and a financial advisor can lay out the full space of options for you to discuss.
Stephanie Bucko and Cristina Livadary are fee-only financial planners based in Los Angeles, California. Stephanie is the Chief Investment Officer and Cristina is the Chief Executive Officer at Mana Financial Life Design (FLD). Mana FLD provides comprehensive financial planning and investment management services to help clients grow and protect their wealth throughout life’s journey. Mana FLD specializes in advising ambitious professionals who seek financial knowledge and want to implement creative budgeting, savings, proactive planning and powerful investment strategies. As fee-only fiduciaries and independent financial advisors, Stephanie and Cristina never receive commission of any kind. Stephanie and Cristina are legally bound by their certifications to provide unbiased and trustworthy financial advice.