Keeping track of performance and returns is a key component of successful investing. Relevant questions investors must ask as they evaluate investment performance is whether the assets in their portfolios are meeting the objective for which they were purchased.
The objective may have been increasing diversification and so helping to moderate risk.
It may have been producing current income or enhancing long-term return. Unlike traditional investments whose performance can be tracked every trading day, investors are often uncertain if an illiquid investment is living up to expectations.
In the most transparent cases, non-traded BDC assets are assigned a fair market value each quarter. Also, non-traded REIT sponsors will have to provide valuations to investors. But many other alternatives are valued on a per-share basis more rarely, if at all.
What’s more, total return — the sum of distributions and any change, positive or negative, in investment value — can be determined readily for traditional investments even though the gain or loss may remain unrealized.
But for alternatives that involve a liquidity event, as REITs and BDCs do, the total return can be calculated only when the investment term ends. So performance can be evaluated only in retrospect.
Defining alternative investment return
A complicating factor for investors accustomed to evaluating relative return, or how an investment performs in relation to a benchmark, is that there aren’t appropriate benchmark indexes against which to measure alternative investment performance. And since one of the primary advantages of alternatives is that they’re non-correlated with the performance of publicly traded investments, the benchmarks that are for traded securities aren’t relevant for non-traded alternatives.
For example, the NCREIF Property Index, published by The National Council Of Real Estate Investment Fiduciaries, tracks the quarterly rate of return on a sample of investment-grade commercial properties. It’s sometimes used to measure non-traded REIT return, but impressions can be misleading. It happens because the index doesn’t account for fees or leverage, both of which have a major impact on performance.
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This helps to explain why alternatives are often described as absolute return investments. This means that gain or loss in value is measured in relation to the investment’s previous value, not to the performance of a benchmark or a comparable investment.
Financial reports
The absolute return of investments that are registered with the SEC can be calculated by comparing the year-over-year data in the audited balance sheets and income statements their sponsors file annually with the agency.
Evaluating a portfolio’s aggregate fair value in relation to its cost aggregate cost is one way to determine unrealized gain or loss over various time periods. And the numbers don’t have to speak entirely for themselves. Any significant differences from the previous period should be explained in the footnotes.
With a REIT or a BDC for example, it’s a good sign when assets are gaining value, income is increasing, and debt ratios are stable. The opposite is true when income is flat or falling and debt ratios are increasing. The state of the economy may be a contributing factor, of course. But it’s also relevant that the investment and management decisions made by a program’s administrators have a major impact on its performance, as do the fees investors pay.
However, many non-registered private placements aren’t required to report on their operations or finances. Thus, it makes measuring and monitoring performance difficult if not impossible.
Income variety
Yield is another way to measure investment performance. And it’s a relevant indicator for alternatives, which are often described as income investments.
A complicating factor is that income from an alternative investment may be either a return of investment or a return on investment. The former means investors are getting their capital back. While the latter means they are receiving profits their capital has generated. REITs and BDCs, for example, are required to distribute at least 90% of their taxable income each year to avoid paying corporate income tax. This is a return on investment. But, in the early years of most of these programs, the sponsors may pay distributions from the capital they have amassed during the offering period if their investments are not yet generating a profit.
These amounts reduce the per-share value of the investment rather than increase the yield. Equipment leasing and energy programs have more flexibility in making distributions. In a leasing program, for example, there may be a revenue-sharing arrangement structure. In other words, during the active operation of the business, the manager takes 1% of the cash distribution and 99% is passed on to the investors. Once an investor has received the equivalent of 100% of his or her investment, plus an 8% return on investment, then the manager takes 10% and the remaining 90% is distributed to investors. Return of investment is generally not taxable. Return on investment is usually taxable, though investors may be able to offset the income with depreciation and other allowances when they file their tax returns.
In conclusion
The challenges of assessing performance during the term of an alternative investment illustrate why pre-purchase due diligence is critical. Certainly, the past performance of a sponsor or management team can’t guarantee future results. So, it may be a key component in selecting among alternatives with the same focus.
It may also be smart for investors to put money into alternatives of the same type, such as REITs or BDCs, rather than into just one. Then, if one provides disappointing distributions or a negative total return, others may live up to expectations.
Alternative Investment Returns. Are They Worth It? by Inna Rosputnia
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