The growing popularity of alternative investments is a testament to their attractive features. Investors who add alternatives to their portfolio have a number of benefits:
- Diversify their portfolios
- Increase their income and total return
- Manage their income tax liability
- Hedge against inflation, recession, or both
- Capitalize on access to a broader range of assets than were previously available.
Of course, no single investment, alternative or not, is appropriate for achieving all these objectives. And some alternatives are better suited for meeting specific goals than others. But individually, and as a group, non-traditional investments offer benefits. It includes the potential to strengthen the performance of an otherwise conventional portfolio.
Diversification tops the list
The benefits of diversification — its potential to reduce portfolio risk and increase investment return — position it as a primary strategy for the majority of savvy investors. Its primary limitation is the temptation to expect too much. As important as diversification is, it doesn’t guarantee a positive return or prevent losses in a falling market.
The particular benefits that alternative investments add to a portfolio stem from returns. Those are non-correlated with the returns on traditional investments and their illiquidity. Of course, these are in addition to the classic benefit of diversification. – By owning a variety of investments that respond differently to changing market conditions, investors position themselves to reap the rewards of whatever asset class or subclass is performing well while also having a stake in whatever class or classes will gain strength as the market moves into the next phase of its cycle of ups and downs.
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What non-correlation adds to the mix is that alternative investment performance is driven by different factors than the ones that impact publicly traded products. For example, while alternative investment performance is not totally divorced from factors such as rising interest rates or falling employment rates, their impact tends to be more muted than for stocks or bonds.
Nor is performance vulnerable to changing investor sentiment. Rather, it’s impacted primarily by the quality of a program’s underlying investments and the effectiveness of its management team. Illiquidity, of course, has drawbacks, but also a potential benefit. Unlike publicly traded corporations, managers of non-traded investments have an extended period to achieve their goals.
Tax reduction tool
Distributions from alternative investments are taxed, in most cases, at the same rate as the investor’s ordinary income rather than at the lower rate that applies to qualified dividends. On the other hand, many alternative investments offer substantial tax relief. Especially it happens early in the program, through a variety of allowances and deductions for, among other things, depreciation and depletion. The rules for claiming these benefits can be complicated. Moreover, they can differ from product to product. So the advice of a tax professional is essential.
Capital gains, which are possible with some alternative products, and may be offset by capital losses, do qualify for the lower, long-term capital gains tax rate.
Welcome income streams
Many, though not all, alternative investments provide a regular stream of income. And it attracts substantial investor interest. Non-traded equity REITs and debt BDCs, energy drilling programs, and equipment leasing programs all strive to be income-producing. In fact, income from alternative investments may be higher than from traditional fixed income products, especially in a low-interest-rate environment.
There can be issues, though. Some alternatives, especially in the early years of a program, pay distributions that derive from capital rather than from asset-generated income. And the distributions aren’t guaranteed and could be reduced or end if the investment fails. With energy programs, in particular, there is no way to predict how long an income stream will last. Especially if the program is small and operates a limited number of wells.
Building a hedge
Another benefit some alternative investments provide is a hedge against inflation or recession. In the case of equipment leasing, you hedge against both. Real return or the percentage gain investors realize after the inflation rate is subtracted from the reported return, is vulnerable to rising inflation rates.
But if a REIT increases the rent it charges its tenants or an equipment leasing company increases its fees in the new contracts it signs, and the company distributes those increases to shareholders, the impact of inflation can be offset. Conversely, in a recessionary period, companies still need equipment to operate and may be even inclined to purchase outright than they are when the economy is healthy. This works in a leasing company’s favor and may increase investor income. The same may be true of those REITs that rent mission-critical properties. But a tough economy also increases the potential for default.
One benefit of alternatives that may be overlooked as they gain widespread acceptance is that these pooled investment structures provide investment opportunities that were until recently available only to high net worth individuals and institutions. The access to commercial real estate through non-traded REITs and private equity ventures through non-traded BDCs are perhaps the clearest examples of the democratization of the capital markets. But they aren’t the only ones.
The same is true of equipment leasing, energy exploration, and other ventures exempt from registration with the SEC but open to non-accredited investors. When these investors participate, however, the sponsor must provide the same offering information and financial statements that would be required if the offering were registered.
Benefits of Having Alternative Investments In Your Portfolio by Inna Rosputnia
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