The break in the inverse relationship between stocks and bonds, something that contributed to fourth-quarter pain in 2018, is happening again. That means what rises together potentially falls together, rendering traditionally safe havens ineffective in times of market turmoil.
Thus, with traditional asset classes moving in tandem, the need for new strategies that act independently of stocks and bonds is increasingly critical.
The level of investor risk is compounded by the sequence of returns, something with which advisors are acutely aware. The dangers of retiring in a down market are well-documented, and damage done to retirement income from lower investment returns is further aggravated by the withdrawal of assets for everyday living expenses — thus making it harder to fully recover losses from the eventual rebound.
Add to this proverbial perfect storm the prediction by Morningstar and others of future lower returns, and this makes it a good time for advisors to introduce alternative investments as a possible solution.
These non-correlated investments, whether tried and true (real estate investment trusts, hedge funds, private equity) or hot and new (opportunity zones), potentially can offer better risk-adjusted returns over time — something that fits with investors’ longer-term retirement income objectives.
How Alternatives Work
Certain liquidity issues aside, there’s increasing interest in the benefits alternative investments provide, yet there’s also confusion about what they are and how they work. While more than half of advisors (65%) are comfortable with alternative investments, nearly as many (55%) cite investor confusion as the reason for a lack of alternative uptake, according to Cerulli Associates.
Yet Cerulli also notes significant adoption, which presents an opportunity for advisors to differentiate themselves, especially for those who take time to understand, explain and incorporate alternative investments in their product and service offerings.
Nontraded REITs, in particular, have proven adept at delivering alternative sources of retirement income, as have hedge funds and private equity.
But due diligence in the form of a comprehensive and transparent “look under the hood,” as well as a greater advisor awareness of new products and trends, is essential to achieving optimal client outcomes.
Retirement Income From Real Estate
The potential to produce income, along with typically lower correlations with the broader stock market, are just two advantages REITs offer. As an asset class, they’ve outperformed gold, oil, the S&P 500, bonds and the EAFE index on an annualized basis for the 20 years ending Dec. 31, 2018, as cited by Financialadvisoriq.com in August.
A nontraded REIT typically has lower volatility and correlation due to its absence from an exchange, and new entrants to the REIT space are offering more institutionally priced products to advisors. Additionally, investors no longer need $1 million or even $100,000 to get in, which is a product evolution for managers, and now a matter of building awareness with advisors.
Advisors with a retirement income focus are currently looking for yield and a somewhat stable net asset value (NAV). As a result, they’re closely watching the REIT’s “life cycle,” where a nontraded REIT performs well enough, and gathers enough assets, to warrant a listed version. At that point, many advisors will sell and reinvest in another non-traded REIT to ensure consistent yield, and the life cycle repeats itself, a trend that is expected to continue.
One area of concern with alternative investments in general is their lack of transparency, traditionally an Achilles’ heel to greater utilization. It’s something that product innovation, and many managers themselves, are addressing, specifically related to fees.
Research firms dedicated to transparency and education are helping advisors lift the hood by analyzing most nontraded REITs’ strategy product types, where they reside in the life cycle, the type of real estate in which they’re invested (residential property versus commercial property), and how are they categorized.
Recent real estate innovation related to REITs is the advent of opportunity zones, economically distressed communities that encourage new investment through favorable tax incentives (such as the reduction or even elimination of capital gains tax).
Created by the tax overhaul in late 2017, both the community and investment must meet certain qualifications; for example, investor capital must be committed for five, seven or 10 years to receive full or partial tax benefits.