Alternative Investments Returns: Are They Worth It?

Unlike traditional investments, whose performance can be tracked every trading day, investors may often feel uncertain about whether an illiquid investment is living up to expectations.

Tracking Performance in Alternative Investments

In the most transparent cases, non-traded Business Development Company (BDC) assets are assigned a fair market value each quarter, while non-traded Real Estate Investment Trust (REIT) sponsors must provide valuations to investors. However, many alternative investments are valued on a per-share basis much less frequently, if at all.

Defining Alternative Investment Return

A complicating factor for investors accustomed to evaluating relative return (how an investment performs against a benchmark) is the lack of appropriate benchmark indexes for measuring alternative investment performance. Given that one primary advantage of alternatives is their non-correlation with publicly traded investments, standard benchmarks for traded securities are often irrelevant.

• Example: The NCREIF Property Index tracks the quarterly rate of return on investment-grade commercial properties. While it may sometimes be used to measure non-traded REIT returns, it does not account for fees or leverage, both of which significantly impact performance. This is why alternatives are often described as absolute return investments, measuring gain or loss in relation to the investment’s previous value.

Financial Reports

The absolute return of investments registered with the SEC can be calculated by comparing year-over-year data in the audited balance sheets and income statements that sponsors file annually.

• Evaluating Performance:
  • One way to assess unrealized gains or losses is by evaluating a portfolio’s aggregate fair value relative to its aggregate cost over various time periods.
  • Significant differences from the previous period should be explained in the footnotes.

Indicators of Good Performance

With a REIT or a BDC, positive signs include:

• Assets gaining value.
• Income increasing.
• Debt ratios remaining stable.

Return of Investment vs. Return on Investment

A complicating factor is distinguishing between:

• Return of Investment: Capital is being returned to investors.
• Return on Investment: Profits generated from the capital.

For example, REITs and BDCs are required to distribute at least 90% of their taxable income each year to avoid corporate income tax, which constitutes a return on investment. In the early years of most programs, sponsors may pay distributions from accumulated capital during the offering period if their investments are not yet profitable.

• Impact on Value: These capital distributions reduce the per-share value of the investment rather than increase the yield.

Conclusion

The challenges of assessing performance during the term of an alternative investment illustrate the critical need for pre-purchase due diligence. Although past performance of a sponsor or management team cannot guarantee future results, it is a vital component in selecting alternatives with similar focuses.

Investors may also benefit from diversifying within alternatives, such as investing in multiple REITs or BDCs. This strategy helps mitigate risks, ensuring that if one investment underperforms, others may still meet expectations.

Wishing you a great week!