Seeking Magnified Returns via Alternative Investments
Where to Find Reliable, Risk-Adjusted Returns on investments…
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Peer-To-Peer Lending
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Short-Term Construction Lending
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Life Settlements
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Merger Arbitrage
Most of us are familiar with the famous fictional private detective, Sherlock Holmes, created by British author, Sir Arthur Conan Doyle. In the stories, Holmes was known as a “consulting detective”, tactically tapped by his clients (often Scotland Yard) for his proficiency with observation, forensic analysis, and logical reasoning, to help solve tough cases.
One of Sherlock’s famous phrases was “whenever you have eliminated the impossible, whatever remains, however improbable, must be the truth”. We at Three Bell suggest that while making solid risk-adjusted returns in the public markets is not necessarily impossible, it is becoming more and more improbable. As such we are looking elsewhere for opportunity. Much like Holmes, we apply many of the same principals and skillsets to assist our clients in navigating the changing (and at present, challenging) financial markets.
Last month, we discussed how the public stock and bond markets are fully priced and adding alternative investments to your portfolio can reduce volatility, increase returns, and mitigate downside risk.
In this edition of “Cutting through the Noise”, we examine alternative investments to overvalued public market investments. Although its anything but, ‘Elementary, my Dear readers’, we believe these alternatives provide clues to where to find higher returns with lower risk. Let’s dive in!
THE BIG PICTURE
Holmes was famous for his use of deductive reasoning to take seemingly disparate facts, and use them to formulate a complete picture of what had actually occurred. Following Holmes’ example, in order to understand where certain alternative investments fit into a well-diversified portfolio, we must first understand where the sum total of all of the world’s investable assets are deployed.
By limiting investment choices to stocks and bonds, we eliminate options in two-thirds (~66%) of the investment world.
Take a look at the chart below. What we can deduce is that public markets (stocks and bonds) actually represent a comparatively small portion of the overall investable universe…and, as we discussed in our last article are the most overvalued cross-section at that.
The vast majority of the public market investment universe (stocks and bonds) is confined to the first four ‘colored blocks’ above, and represents just $159T out of a total $437T of investable assets. By limiting investment choices to stocks and bonds, we eliminate options in two-thirds (~66%) of the investment world.
However, almost all of that remaining $300T can be accessed through some form of private offering, typically through a hedge fund framework, that can blend nicely with a public market portfolio. On that note, let’s take a look at some of the specific alternative investment strategies Three Bell is currently leveraging on behalf of our clients to help mitigate the volatility of the broader stock and bond markets, as part of a well-diversified portfolio.
…many new private credit markets [sic] can offer disproportionate returns to those available in the public fixed income market.
TYPES OF ALTERNATIVE INVESTMENTS
Our last edition of “Cutting through the Noise – Think Alternative(ly)” broadly discussed alternatives as an asset class. However, there are a wide variety of investments that fall within that category and generate returns in vastly different ways.
Credit Market Niches’
The financial crisis of 2008-09, which was first and foremost a credit crisis fueled by defaulting subprime mortgages, resulted in many changes to the banking sector. The sum total of these changes was a substantial pullback from banks offering certain types of financial products, and a “back to basics” mandate. The net response to these changes is many new private credit markets that can offer disproportionate returns to those available in the public fixed income market.
Peer-To-Peer Lending Funds
A specific niche type of lending platform that has gained significant traction since the Financial Crisis is peer-to-peer (P2P) lending. This category looks to serve the individual loan market that does not want to borrow through unsecured, revolving credit (eg credit cards).
Lenders (in our case, a hedge fund) extend credit, often at rates similar to credit cards, but allow borrowers to amortize that debt from the outset, enabling borrowers to see the light at the end of the tunnel and thereby dramatically reduce instances of default. These lenders can then pass along high returns to their investors because they operate much more efficiently than the big banks.
One such hedge fund utilizes a complex algorithm that evaluates and weighs over 1200 different unique data points for each loan, then uses a high-speed trading conduit into the lending platforms to purchase the best loans within 40 milliseconds. This pretty much leaves the little guy out of the equation, but does offer an excellent risk-return profile to investors in such funds.
What do we like about this alternative investment?
- Consistent, high single digit, low double digit returns since inception (currently annualizing at approximately 12% net of fees)
- Little to no correlation with the stock or bond markets
- Maximum loan size is $30K and most are 3-year loans, which means a fund investing tens of millions of dollars is going to own a LOT of loans that are paying off in a relatively short period of time
- Personal loan deficiencies consistently remain lower than other loan types, including auto loans, mortgages, and credit cards. Supporting data illustrates this further.
- 9% of investors in this market segment have made money in personal lending over the past 10 years.
- Default rates through the Financial Crisis needed to be 70% more severe before investors would have lost ANY money in this asset class (see chart below)
Short-Term Construction Lending Funds
Traditional banks lost their shorts in the Financial Crisis, partly because they had loaned money to real estate developers who walked away from unfinished projects, forcing the banks to repossess the properties. Worse, global Basel III commercial banking regulations written after the Financial Crisis prohibited the banks from holding the assets until they recovered their value, and banks were thus forced to liquidate in a fire sale, locking in substantial losses.
Due to those regulations, many traditional banks exited the short-term construction lending sphere, which left a void of capital for real estate developers that needed to borrow money to build their properties. Enter private real estate debt funds…
There are many high return business models that lend themselves well to the private, hedge fund format.
Because of the scarcity of capital for real estate projects, hedge funds that effectively analyze and pick high quality, low risk projects, can charge double-digit interest rates on what are typically relatively short term loans (1-3 years), and are then cashed out of the project entirely when the development is complete and the debt is refinanced with a traditional bank and long-term debt.
What do we like about this alternative investment?
- High annual interest rates of approximately 12% net of fees
- No property depreciation risk since not buying the asset, just loaning funds
- Short term loan duration of 1-3 years
- Senior secured debt gets paid off first in the event of default
- Maximum 70% LTV established at time of investment
- Ability to repossess property at a very low cost and hold that property or develop it to maximize investor returns (thus eliminating need for fire sales)
- Little to no correlation with the larger stock or bond markets
Special Situations
There are many high return business models that lend themselves well to the private, hedge fund format. These opportunities vary in their reliance on the underlying stock and bond markets, but one variable remains the same… the overall correlation to the public markets is historically very low.
Life Settlement Funds
A life settlement is the transfer of ownership and beneficiary rights of an unwanted or unneeded life insurance policy in exchange for a cash settlement. The seller of the policy no longer has the responsibility of paying future premiums. In exchange, buyers (investors) profit based on the difference between the face value of the policy (death benefit) and the aggregate of the acquisition price, plus accumulated premium costs.
The typical returns for investors in these policies have been 10-18% per year with very little volatility, as seen in the graph below.
The life settlements industry, and returns thereon, are expected to continue to grow due to 1) projected increases in the US senior population and a resulting larger pool of policyholders potentially looking to sell, and 2) the large gap between the current size of the life settlement market (under $20B) and the value of the individual policies that lapse or are surrendered each year (over $640B).
What do we like about this alternative investment?
- There is little to no correlation to the larger stock and bond markets
- Returns are well into the high teens every year since inception
- Returns are very stable and experience very little volatility
- The underlying policies are with investment grade carriers
- Returns are almost all long-term capital gains making it very tax efficient
Merger Arbitrage Funds
Merger arbitrage entails investment in event-driven situations such as leveraged buyouts, mergers, and hostile takeovers. Because of the risk that a merger will not close, the target company’s stock will typically sell at a discount to the deal price. This pricing discrepancy or “spread” is a merger arbitrage fund’s potential profit.
There are a variety of reasons why a merger might fail, creating this opportunity, including government antitrust rulings, financing failures, and shareholder rejections. However, with proper position selection, a merger arbitrage fund can largely immunize itself against stock market fluctuations. This is due to the fact that the fund isolates its exposure to the compression of the spread between only two stock prices, the acquiring company and the target company. Thus price movements at the market level become largely irrelevant.
What do we like about this alternative investment?
- Returns for the fund we utilize have annualized at approximately 28% since inception, net of fees
- Low-interest rates and a sluggish economy should lead to increased M&A activity
- At 170 announced deals, there are a lot of potential mergers to address
- The Dodd-Frank Bill forced many investment banks out of merger arbitrage, lessening competition
- Arbitrage spreads tend to be positively correlated to overall interest rate levels (profit tends to increase along with interest rates in a rising rate environment)
- Fund strategy isolates returns from larger stock market fluctuations, reducing correlation and providing true diversification
THE SCIENCE OF DEDUCTION
Based on an extensive examination of all the clues presently available, we deduce that the public markets offer more risk than return. That said, no one can predict the market, and there is always the possibility that it pushes inexorably higher.
In response to this upsidedown risk-return paradigm, we do not suggest investors retreat to the unacceptably low-interest rates available in money funds. Rather, we can utilize certain alternative investments to continue to produce stable returns by investing in funds whose underlying assets and strategies are not tied to the stock and bond markets.
Through the use of alternative investments, in concert with stock and bonds, our intention is not to predict the market, but rather prepare for all outcomes.
Disclosures
Three Bell Capital (“Three Bell”) is a registered investment adviser with the Securities Exchange Commission. The information provided by Three Bell (or any portion thereof) may not be copied or distributed without Three Bell’s prior written approval. All statements are current as of the date written and does not constitute an offer or solicitation to any person in any jurisdiction in which such offer or solicitation is not authorized or to any person to whom it would be unlawful to make such offer or solicitation.
This information was produced by and the opinions expressed are those of Three Bell as of the date of writing and are subject to change. Any research is based on Three Bell proprietary research and analysis of global markets and investing. The information and/or analysis presented have been compiled or arrived at from sources believed to be reliable, however Three Bell does not make any representation as their accuracy or completeness and does not accept liability for any loss arising from the use hereof. Some internally generated information may be considered theoretical in nature and is subject to inherent limitations associated therein. There are no material changes to the conditions, objectives or investment strategies of the model portfolios for the period portrayed. Any sectors or allocations referenced may or may not be represented in portfolios of clients of Three Bell, and do not represent all of the securities purchased, sold or recommended for client accounts.
- Alternative Investments
- Investments
- Life settlement fund
- merger arbitrage
- Peer-to-peer lending
- real estate lending
- Risk-Adjusted Investments
