Alternatives 2.0: Innovative Ways to Diversify Your Portfolio

1 month ago - November 02, 2022
Alternatives 2.0: Innovative Ways to Diversify Your Portfolio
Host of innovative alternative strategies could bolster investors’ portfolios as traditional assets face headwinds.

Investors’ expectations of returns on stocks and bonds—as well as the diversification potential between the two asset classes—are being challenged by high inflation and tightening monetary policy. In this environment, investors are becoming increasingly interested in alternative investments to further diversify portfolios.

Alternative strategies, such as those focused on hedge funds, private capital and real assets, have long been appealing as a potential source of higher yields, lower volatility and returns uncorrelated with stocks and bonds. Still, such strategies typically have been reserved for institutional and ultra-high-net-worth investors, out of reach for many individuals.

That is now changing. A host of innovative investment vehicles has recently become available to a wider range of sophisticated investors. They tend to offer improved liquidity, lower investment minimums and simpler tax-reporting requirements, among other features that render them more investor-friendly.

Individual investors may want to consider these “registered” offerings—that is, registered under the Investment Company Act of 1940 that regulates investment funds to minimize conflicts of interest and increase transparency.

* Interval funds invest in various asset classes, most commonly in credit. They do not trade on an exchange but offer investors the chance to redeem shares at certain “intervals,” such as quarterly or annually. In exchange for accepting this illiquidity, individual investors gain access to institutional-level strategies that can offer a potential return advantage and further diversification, while getting the benefits of greater regulatory oversight, lower investment minimums and less-complex tax reporting.

  • Perpetual, or continuously offered, business development companies (BDCs) provide direct, privately negotiated senior loans to middle-market companies. They aim to generate high current income through multiple sources, including coupons and origination fees. Investments in direct loans are less liquid than traditional fixed-income investments and, for that, offer a premium. The perpetual BDC structure offers investors exposure to these traits of private credit, without the intraday volatility of public BDCs or the illiquidity of private BDCs.

  • Nontraded real estate investment trusts (REITs) offer investors access to a portfolio of commercial real estate assets. This strategy aims to provide an income stream with low correlation to stocks and bonds, while serving as a potential hedge against inflation. Exposure to real estate through nontraded REITs can be particularly compelling today, given the vehicle’s diversification across property type, location and tenant mix. Over the years, the nontraded REIT industry has evolved from one beset with illiquidity and high fees to one with more-transparent pricing, improved liquidity and more-robust oversight.

* Registered funds of funds (FOFs) are multi-manager investment vehicles that invest in portfolios comprising other funds. Registered FOFs typically have lower income requirements and minimum investment amounts than private FOFs.

Specifically, registered funds of hedge funds offer access to multiple hedge fund strategies. Hedge funds as an asset class have proven to be resilient, particularly during periods of significant equity market volatility and drawdowns. Compared with their private counterparts, registered funds of hedge funds charge marginally higher fees, due to additional operational and regulatory expenses. At the same time, they are accessible to a broader audience through lower minimums and eligibility requirements, and they provide 1099 tax reporting, which is considered more investor-friendly than the K-1 tax forms issued to investors in private funds of hedge funds.

Meanwhile, registered private equity FOFs invest in a portfolio of private equity managers, providing investors with sector, strategy and vintage-year diversification. These funds can be structured either similarly to private placement funds, with a capital-call phase and no liquidity, or as evergreen vehicles with periodic subscriptions and limited liquidity.

While many of these registered offerings may be attractive, investors need to remain selective and fully understand the benefits and risks, particularly as they relate to illiquidity. As we enter the next phase of the economic cycle, we expect the evolution of the alternative landscape to continue and the suite of product offerings to mature and expand. Talk to your Morgan Stanley Financial Advisor how these strategies might play a role in your portfolio.

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