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Do Wall Street’s smart-money investors have an easier time than you do wresting income from their portfolios? Maybe. But it doesn’t have to be that way. You can use their tricks too.
Like you, they have to deal with market risk, default risk, credit risk and the like. Also like many other investors, the smart money — high-income or high-net-worth investors, who can afford investment advice from the priciest financial advisors — uses traditional income strategies. But smart-money investors also make more use of alternative strategies than they did, say, five or 10 years ago, estimates Tony Hallada, managing partner at CliftonLarsonAllen Wealth Advisors (CLA). And they use those strategies more than Main Street investors do.
“They have to, as there is little to no yield in traditional assets,” Hallada said.
Traditional sources include dividend-paying stocks, investment-grade corporate bonds and Treasuries.
Alternatives, to most investors, are anything that is not a publicly traded stock or bond. Alts — as many investors refer to them — typically range from direct investments in commodities such as gold and real estate, to investments in private equity and private credit funds. Asset management giant BlackRock also counts as alts some securities that are publicly traded — such as U.S. REITs, master limited partnerships (or MLPs, which often focus on running pipelines to transport energy) and preferred stocks — but whose performance often is not in lockstep with the broader stock market.
IBD’S TAKE: To learn about a top income investor’s insights into such sources of income as convertible bonds, preferred stock and high-yield stock, read this IBD question-and-answer interview with Fidelity Investments’ Joanna Bewick.
In fact, the absence of performance correlation with most stocks and bonds is one of the two most attractive benefits of alts. That helps diversify investors’ portfolios. The other benefit is that their yields tend to be higher than the yields on traditional assets.
Among traditional assets, 10-year U.S. Treasuries averaged yield of 2.37% as of Nov. 30, according to the Bloomberg Barclays index for those bonds. High-yield bonds averaged yield of 6.57%. Other categories were around 4% or less. Alts such as midstream MLPs averaged 5.3%. U.S. dollar denominated emerging markets debt averaged 5.13%.
Other alts’ yields tend to be even higher. Three types of alts used by Hallada are private real estate, private credit and private equity. Hallada offers clients of CLA who are interested opportunities to invest in funds organized by other investment shops. It is somewhat akin to investing in a mutual fund, except these alt funds are not publicly traded. “Generally, investors only know about these funds because their financial advisors have access to them,” Hallada said. “So, I would say you need to consult an advisor to invest in one.”
- Private credit. One type of private credit fund that Hallada’s clients use buys nonperforming home loans from banks and reworks the terms with borrowers, who can then remain in the home. The fund aims to make the borrowers’ new monthly payments less than comparable rents in the local market. That motivates borrowers to keep making payments. Risks include borrowers’ reverting to nonpayment and a softening economy that hurts other homeowners’ ability to pay off loans. Yields for investors in the fund are currently 8% to 10%, Hallada says.
Hallada is also involved in private credit funds that make mezzanine loans to commercial real estate developers. These loans provide financing for the portion of a project’s cost that a bank won’t cover. Risks include a developer becoming unable to pay back loans.
Some of Hallada’s private credit funds lend money to online lending platforms.
- Private equity. This can involve a fund that invests in or takes over a private business. Perhaps an aging owner wants to cash out but can’t find a permanent buyer. Hallada is familiar with funds that have stepped in as temporary owners of car dealership and waste management businesses. The fund retains an interim manager until it can resell the business. The main appeal for the fund is a chance to sell at a profit, but in the meantime the investment also offers income, which can translate into an 8% to 10% yield, he says. Risks include a softening economy and the fund’s inability to sell a business as soon as expected.
“All the usual advice about due diligence applies to these types of investments,” Hallada said. “Be careful about chasing yield. Don’t jump into a fund just because it worked in the past. Know who you’re investing in. Understand all of your risks.”
Dennis Moon, U.S. Trust’s head of specialty asset management, finds private timberland, farmland and real estate investments for clients.
“A person of significant wealth could allocate 10% of his total portfolio to these assets,” Moon said. “For most people, 5% is more appropriate.”
Clients typically are sole owners of an asset. And Moon customarily finds more than one investment in a category for each investors, for the sake of diversification. He diversifies further by regional location and type of property or product.
Moon accepts clients with at least $50 million in net worth who can invest at least $5 million in a fund. Other advisors’ requirements may differ.
Annual total returns for timber, farmland and commercial real estate tend to be roughly 8%-10%.
In addition, Moon’s team arranges for a third party to manage the asset unless an investor wants to run timberland, a farm or commercial property. Even after management costs, annual yields for his clients on timberland are in the 2.5%-3.5% range and for farms in the 3%-4% range.
Yields for commercial real estate fall into the 4%-7% range, depending on such things as the type of property.
Both for liability protection and estate planning, Moon’s team creates a limited liability corporation (LLC) or limited liability partnership (LLP) as the vehicle of ownership.
“For all three categories, total return and yield can vary depending on where we are in their economic cycles,” Moon said. “There’s more upside to timber now because we’re still in the fairly early innings of the housing recovery.” Timber is used not only in construction but also in fuel, paper, packaging, diapers and feminine hygiene products. And aging global populations are raising demand for such things as adult diapers.
Farm prices are currently mixed, with more strength in the Midwest than California, Moon says. But long term, “people have got to eat,” Moon added.
Within commercial real estate, Moon expects the strong multifamily market to top out soon. He expects demand for industrial properties to continue to grow. He is neutral on the outlook for offices and expects volatility in the market for retail space.
Why not make comparable investments through real estate investment trusts or REIT mutual funds and exchange traded funds? “Publicly traded REITs correlate too much to the broad stock market,” he said. “But the biggest reason is control over the property. Having full ownership, you have direct access to the property manager. The disadvantage is that you may have to invest more with us than you would with a REIT or REIT fund.”
Moon generally requires at least a $5 million investment from his clients.
While Moon sticks to timber, farmland and commercial properties, other advisors offer comparable investments in asset such as oil and gas.