Need Stable Income? Worried About Inflation? Concerned About Stock Prices? Alternative Investments May Help
Ideally, your portfolio has a mix of investments that may allow you to build a nest egg and income stream to find your retirement goals. You may own tried-and-true stocks and bonds. If you're like many investors, you may have several index funds spread out between large- and small-cap stocks or funds with US and international stocks. Same for different types of bonds. But everyone does. So, how much diversification are you really getting when you own an S&P 500 Index fund? Sure, this type of fund, in theory, gives you exposure to 500 stocks in the index. But the reality is that these funds have a high concentration in the "Magnificent Seven", a group of high-performing and influential technology-oriented stocks that includes Amazon, Google, Meta (formerly Facebook), Apple, Nvidia, Microsoft, and Tesla. While the stories of these stocks are compelling and they have powered the growth in stock indexes, are you prepared for the possible impact on your retirement investment goals if something happens? What if you need stable income? Or are worried about inflation or afraid that stock prices will drop? This is where alternative investments may help. Alternatives can add uncorrelated investments to your portfolio that may boost your diversification efforts and help protect your portfolio.
Protection Against Rising Prices
While inflation has moderated, we all recall the dramatic run-up in prices at the gas pump and grocery store with 9%+ year-over-year inflation. Although inflation has come down to earth and is closer to the Fed's target and the historical long-run average (<3% year-over-year changes), it can flare up at any time. One of the adverse impacts of inflation is that it adversely impacts the purchasing power of your money. A dollar doesn't go as far as it used to and buys less stuff. And increased inflation hurts the value of bonds as well as the income stream from them. How can an investor protect against this?
One way to hedge against this impact is to hold commodities. These include oil, gas, agricultural products like soybeans or wheat, timber, and industrial or precious metals. Typically, when inflation flares up, it happens when the economy is expanding. This drives demand for such commodities. By owning them, you can offset some of the negative impact of inflation in an expanding economy. While there are various individual stocks or even index funds for each of these commodities, you can make this more manageable by owning a mutual fund or Exchange Traded Fund (ETF) that combines these various commodities into an all-in-one investment.
Protection Against Income Shortfalls
Inflation can hurt the value of your bonds. The underlying prices of bonds (individual bonds, bond mutual funds, and bond ETFs) go down when inflation spikes and newer bonds that are issued have offer higher interest rates. This also means that your older holdings are paying you less income than newer offerings in these investments. So, you'll also want to protect against your income dropping during inflation spikes.
Alternative Bonds
One key way to protect your portfolio is to consider alternative income strategies that provide broader, more diversified income streams than the typical bond index fund. Alternative bond funds include more than US and corporate AAA-rated debt. They can include legal-settlement finance, reinsurance, movie financing, or collateralized lending such as real estate, equipment leasing, and accounts receivable financing. Typically, these are available through "interval funds" which are a variation on a closed-end fund and requires a lock-up period restricting redemptions to a quarterly window instead of daily. In exchange for this arrangement, yields offered are much higher (typically > 8%) than yields offered by more "plain vanilla" open-end mutual funds. There are diversified funds that include all of these strategies in one fund.
Floating Rate Note Funds
Another key bond investment that can counter inflation and income shortfalls is a floating-rate bond fund. Such funds provide higher yields and are tied to underlying bonds or notes made to companies that include terms that frequently reset how much the borrower pays tied to some index and inflation. Think of these like a variable rate mortgage, but the borrowers are companies instead of homeowners.
Closed-End Funds
Another way to boost income is to use closed-end funds. CEFs are available for both equity and bond investments. They differ from an "open-end" mutual fund in that they are issued with a set number of shares much like any company stock. Investors can buy and sell their fund interests in much the same way someone trades a stock. Price is based on supply and demand. The fund itself doesn't redeem an investor's holdings when the investor wants to liquidate. So, this means the fund has more cash available to invest in the underlying investments. The CEF itself may also use borrowed funds to invest in more of the underlying bond or stock investment. Combined, this boosts the potential yield payout you receive.
Business Development Companies
A type of CEF, business development companies (BDCs) invest in mid-size and small private and small public firms that have low trading volumes or are in financial distress. Sometimes these are companies that are backed by private equity and need cash for working capital, expansion, or R&D. The private-equity backers may not want to dilute their ownership by raising equity from investors. So, borrowing is more attractive. Since traditional banks may be restricted by underwriting requirements or regulated minimum capital needs, the BDCs fill the need and are typically highly rewarded offering their investors, in turn, high yields.
Hedging Equity Market Risks
If you're invested in the stock market, you'll have to expect that market prices can go down as well as up. After all, trees don't grow to outer space. And gravity applies as much to the stock market as the physical world.
From peak to trough, US stocks declined in nominal dollars between 45% and 55% in multiple time periods: 1973-1974, 2000-2002, and 2007-2008. Market corrections of lesser amounts are not unheard of as well: 34% during the CORONA Virus sell-off; 20% during the tech bubble sell-off in early 2000; 10% during the Asian and Long-Term Capital Management crises near the end of the 1990s. So, during poor markets, investors should expect the risky portion of their portfolio to decline by up to half. The “risky asset portion” is everything that is NOT investment grade bonds or cash. For example: An investor with a $1M portfolio with 60% in stocks and 40% in bonds and cash should expect to experience a decline to $300,000 periodically. This is the necessary pain to achieve the higher returns that are expected from risky assets. This is not a “worst-case” scenario but an expected periodic case. If stocks did not occasionally experience losses, they would cease to be attractive to earn superior returns over the long-term.
Buffer ETFs: Define Your Outcome
So, what to do when your crystal ball is cloudy? This is where new financial products may help. Since late 2020, Wall Street has launched an expanding array of so-called "buffer" ETFs that incorporate derivatives using various hedge strategies to generate extra dividend income and/or protect against stock market losses. Such products are ideal in allowing investors to continue to participate in the market without just staying on the sidelines in cash potentially missing out on market upswings.
These funds work by holding a basket of securities or using one "reference asset" such as the S&P 500 Index in the form of the SPDR S&P 500 Index Trust (SPY) while also selling (or "writing") call options on those same underlying assets. If the market value of the basket or reference asset goes up, the investor gets the upside gain limited by some cap. If the market value of the basket or reference asset goes down, the options provide a hedge to buffer against the downside. In either case, there may be income generated for the investor from the writing of the call option. In addition to providing a market hedge, these ETFs can be combined to create a target income for retirement while limiting the need of selling off assets.
While generally a good tool for hedging equity market risk, they can also be used to draw investor cash from the sidelines that would otherwise not earn anything significant in a brokerage cash account. Some firms are offering ETFs with 100% downside protection against the equity basket. Sure, there's a cap on the upside (say, 9.8%), but that's still higher than what any cash account is paying.
Other hedge strategies combine investing in an index with hedge strategies such as "managed futures" typically reserved for higher-cost separately managed accounts (SMAs) or "hedge funds."
Last Word: Investors Win When They Don't Lose
The role of diversification is to help investors reach their individual goals. In the right proportion for a client's risk profile and income need, a combination of alternative strategies can help a client stay on course, increase the stream of income for lifestyle needs, and reduce the risk of drawdowns inherent with equities. Adding alternative strategies as part of an individualized portfolio program may help.
For more information on how this approach may work for you, please reach out to Steve Stanganelli, CFP at Clear View Wealth Advisors, LLC.
