Investing 202

Alternative investments cover a broad range of investments including real estate investment trusts (REITs), business development companies (BDCs), private equity, hedge funds and collateralized loan obligations. They typically have low correlation to the stock market, making them useful for diversification. See the topics below for additional descriptions.

Some of these investments are restricted to specific segments of investors while others are available to all investors. It is important to carefully consider these investments as many of them are not publicly traded so they lack liquidity. While offering higher returns in some cases, that can often come with increased levels of risk.

REITs own and operate various types of income-producing real estate. REITs will frequently own multi-unit housing developments, retail and office spaces. Because of trends related to remote and hybrid work, some REITs are moving away from office space and navigating toward real estate where remote work is less common such as industrial and healthcare real estate.

REITs are required to distribute 90% of their taxable income to shareholders as dividends. REITs are subject to the same risks as any real estate investment such as interest rate risk, inflation and the ability of the lessee to pay.

A BDC is another type of real estate investment. In comparison to a REIT, a BDC typically provides financing to smaller enterprises and distressed properties. They typically have higher yields than REITs but are also considered to have higher risk.

Collateralized loan obligations or CLOs are not the same as the CDOs that became infamous during the 2008 financial crisis. Both contain securitized debt but CDOs contain a more broad range of debt instruments which have historically contained things like subprime mortgages.

CLOs issue debt “tranches” of various credit quality, with a senior, high quality AAA rated tranche, lower rated tranches referred to as “mezzanine” tranches and an equity tranche, which is generally the highest risk tranche as it is the last to receive repayment in the event of default. Most CLOs specifically contain securitized debt from select corporations rather than the broad collection of bonds and mortgages of CDOs. With a CLO, it is easier to assess the creditworthiness of the underlying loans of the corporate debt.

While it is possible to purchase from a single tranche, this is typically done by institutional investors. Retail investors invest in CLOs by purchasing a range of CLO tranches, usually through a mutual fund or ETF.

CLOs are not without risk. CLOs are still subject to risks such as credit risk and interest rate risk.

The traditional role of private equity is to purchase distressed companies, bring in new leadership, restructure the company to improve cash flows and resell the company. This is typically done through a leveraged buyout (LBO).

Many of the major private equity firms such as Blackstone, KKR and others will also engage in venture capital where they provide funding for companies that have not yet reached the growth stage.

These types of investments are not publicly traded. They are restricted to accredited investors and institutional investors. Individuals seeking to invest in private equity are required to meet income and net worth minimums.

Hedge funds, like mutual funds, pool money from investors to make investments. Hedge funds take on significantly more risk than most mutual funds and don’t have the same regulatory requirements that mutual funds have. They will often have positions that are heavily leveraged or use complicated derivatives.

Hedge funds usually have higher fees than most mutual funds, employing a “2 and 20” fee system which is a 2% management fee with a 20% performance fee. They are normally only open to accredited and institutional investors.