Alternatives
Young, wealthy investors (ages 21-43) are gravitating towards alternative assets like hedge funds, private equity, and crypto, with nearly one-third of their portfolios in these categories.
They allocate less than half of their portfolios to traditional stocks and bonds, contrasting with older investors who prefer these conventional investments. This younger generation's investment preferences are shaped by greater access to diverse asset classes and experiences like the financial crisis.
They also hold higher cash allocations for liquidity, despite the potential risks of underinvesting. Diversifying into alternatives comes with unique costs and risks, including higher management fees and illiquidity.
Finsum: The introduction of crypto and many web 3.0 products have really spurned the growth of alts for younger investors.
Alternative investing, which includes assets like private equity, real estate, and hedge funds, is becoming more accessible beyond just the ultra-wealthy and institutions. These investments can enhance portfolio diversification and potentially mitigate risk due to their low correlation with public markets.
Utilizing self-directed IRAs for alternative investments offers the added benefit of tax-free growth. The popularity of alternative assets is rising, with private market assets growing significantly and individual investors currently holding a small percentage of these assets.
Diversifying with alternatives can help manage market risk, especially during volatile times. New investment platforms are making it easier to access alternative investments, allowing for a more customized and balanced portfolio approach.
Over the past twenty years, alternative investment strategies like hedge funds, private equity, and real estate have grown in popularity among investors seeking diversification and steady returns. This trend was initially driven by the low-yield environment post-2009 financial crisis, making alternatives attractive due to their higher yields and low correlation with public markets.
However, the landscape shifted post-2021 with rising inflation and interest rates, as well as increased geopolitical tensions, challenging traditional investment approaches. Hedge funds have gained renewed relevance, offering uncorrelated returns amid market volatility.
Similarly, private credit has thrived, benefiting from the retreat of large banks from direct lending and providing attractive yields and diversification. Despite rising interest rates, alternatives with lock-up periods continue to outperform public markets, supporting a balanced, blended investment strategy for consistent returns.
Finsum: Remember the real advantage to alts is their uncorrelated returns and more specifically uncorrelated volatility to traditional markets.
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The term beta represents an investment’s volatility relative to the overall market and is a concept that experienced investors understand well. Beta measures the sensitivity of an investment to overall market movements and is a measure of systematic risk, with the market typically represented by a broad index like the S&P 500.
High beta stocks exhibit more volatility and are typically growth stocks, while low beta stocks are less volatile and often include value stocks in defensive sectors. But this approach should be used when thinking about alternatives because they are being used to balance a portfolio.
Beta can change over time due to economic conditions and changes in a company's operations or industry. When assessing alternative investments, combining beta with correlation provides insight into an investment's potential role in a portfolio, enhancing diversification and risk management.
Finsum: You don’t need complicated financial models to assess beta, and integrating this historical return factor could greatly improve portfolio performance.
There are increasing concerns that a crisis is brewing in commercial real estate (CRE), as over the next couple of years, $2 trillion in CRE loans will need to be refinanced. Previously, there were hopes that macro conditions would soften, leading to lower rates and a more favorable lending environment. Instead, inflation has proven to be more resilient than expected, and expectations of Fed dovishness have been dialed back.
In addition to high rates, major challenges include decreasing demand for offices and rising vacancies, a stricter lending environment, and balance sheet woes at regional banks, which traditionally account for a large share of CRE lending. However, there is significant variance within the CRE market. Areas like data centers, hotels, and industrial buildings continue to show strength, while retail and multifamily exhibit more mixed performance.
If conditions worsen, there is a risk of spillover effects on the broader economy, including decreased lending activity due to losses at banks, lower tax revenue for local governments due to more vacancies and lower property values, and subsequent declines in hiring. However, the consensus continues to be that there won’t be a full-blown crisis as the sector is sufficiently diversified and continues to have strong credit performance despite adverse conditions.
Finsum: Investors should pay attention to the CRE market given the refinancing cliff and challenges posed by higher rates and a stricter lending environment.
Traditionally, fixed income is where financial advisors look to reduce portfolio risk. This is no longer the case in the post-pandemic period, as the bond market has experienced major volatility, which is becoming the norm in a high-rate, high-inflation regime.
Given these conditions, investors may be better off with fixed index annuities (FIAs). Like bonds, FIAs produce income; however, a key difference is that FIAs guarantee an income stream for life as opposed to a fixed period. Another advantage of FIAs is that they have higher earnings potential than bonds, given that many are designed to earn interest based on the performance of an external index like the S&P 500. In contrast, fixed income has significantly underperformed over the last 5 years and failed to beat inflation.
Over long periods of time, costs matter when it comes to long-term investing. Most bond investments have fees that range between 0.5% and 2%. In contrast, FIAs tend to have much lower fees, on average.
In terms of risk, FIA offers full protection of the principal investment. This means that it can be more effective than fixed income to hedge equities, especially in the current environment. Overall, FIAs can be more effective than fixed income, especially for investors who are in or nearing retirement.
Finsum: Advisors should consider fixed indexed annuities (FIAs) as an alternative to fixed income, especially in the current environment. FIAs offer lower costs, more downside protection, and greater potential for appreciation.