Following is an overview of several alternative investments that didn’t warrant their own posts:
Convertible Bonds. These are bonds that are convertible into shares of stock. They are mostly traded by hedge funds using sophisticated arbitrage strategies. We do not use these in portfolios as they aren’t different enough from stocks to make the diversification compelling. They are equivalent to having a bond portfolio combined with call options on the related stocks. Because of the call option the yield on the bonds are lower than they would otherwise be.
Preferred Stocks. Preferred stocks are mostly owned by corporations due to the special tax treatment (there is a dividend exclusion for companies). While preferred stocks are senior to common stock in the capital structure, they are junior to all debt. This means in the event of bankruptcy, there is likely to be little, if any, recovery. These stocks are not typically a compelling investment for individuals. While they are technically stocks, they more closely resemble bonds in most cases.
Hedge Funds. A hedge fund really isn’t an investment strategy, it’s a compensation method. There are a wide variety of funds so it is difficult to paint with a broad brush, but in general:
- In the U.S. hedge funds are only available to accredited investors – those who have a net worth of over $1 million excluding their primary residence, or an income over $200,000 ($300,000 with spouse) for the last two years and expected for the current year.
- The fees are high (though worth it if in fact they are delivering alpha), and are most commonly “two and twenty” – two percent of the value plus twenty percent of any profits.
- They require minimum investments that preclude even relatively wealthy investors from owning enough of them to diversify properly.
- Hedge funds of funds solve the previous problem but at the cost of another layer of fees.
- It appears hedge fund outperformance may have existed when there were fewer of them, but it probably doesn’t exist any longer.
- To the extent there is (or was) outperformance it is (or was) concentrated in a very few funds that have such restricted access you (or I) are unlikely to be able to get in. (Groucho Marx said, “I would not join any club that would have someone like me for a member.” Similarly, you don’t want to invest in a hedge fund that would allow you to do so.)
- While ostensibly charging high fees for alpha (outperformance) it appears in practice they are delivering a great deal of beta (simple market performance) which should be nearly free.
- The strategies are opaque and illiquid.
We do not invest in hedge funds or encourage clients to do so either.
Master Limited Partnerships.
- These have historically been owned by investors in taxable accounts for the favorable tax treatment, but it comes with increased tax complexity (K-1s) that investors dislike.
- If the positions are large, it may cause the investor to have to file state income tax returns in states where the partnerships are located.
- If the positions are large and located in a retirement account, it could result in UBTI (Unrelated Business Taxable Income) which is taxed at trust (i.e. high) rates. Further, this does not create any basis in the account and thus will be taxed a second time when it is distributed to the owner. This is very unfavorable.
- It would be difficult to diversify properly among individual MLPs given the very small weight it would have in even a relatively large portfolio.
- Recently Exchange Traded Notes (ETNs) and Exchange Traded Funds (ETFs) have been created that remove some of the favorable tax treatment (particularly with the ETF), but offer diversification and 1099 treatment.
- Like REITs, I think the best metric is the current yield. Past total returns should probably be given little weight.
- They have very low correlation to stocks; higher than commodities, but less than high yield bonds, and high yield is also the asset class to which they have the highest correlation.
- MLPs should actually go up with inflation.
The returns on MLPs can be attractive relative to high yield and offer additional diversification.
High Yield Bonds. These are also known as “junk bonds” or “non-investment grade bonds.”
- These are somewhat like covered call writing on an equity portfolio, and should produce high returns in moderate periods, little extra upside potential in good times, all the downside in bad times. In other words, the distribution has negative skew.
- These can be very good for “muddle through” markets. If the economy booms, stocks win. If the economy tanks, investment grade bonds (particularly treasuries) win. But in a slow growth environment where companies are neither doing extremely well nor going out of business, high yield can do relatively well.
- Some analysts believe these are unnecessary in a portfolio of stocks and bonds as they are merely a hybrid of those two. I find a significant idiosyncratic element that leads to improved portfolios because of the increased diversification.
High yield bond funds can have a place in client portfolios, but in small proportions and as part of the stock (i.e. “risky”) portion of the allocation rather than the fixed income portion.