While the bulk of the investments we recommend are either stocks or bonds, we do recommend a few assets that don’t fall into either of those categories. These specialized investments are:
- Alternative lending
- Real estate
Reinsurance is insurance purchased by insurance companies. Just as individuals and families purchase insurance to protect against large losses to their homes, cars, etc., insurance companies buy coverage to protect from potential large and/or widespread losses, including natural disasters, such as hurricanes and earthquakes, as well as major commercial accidents. Some of the most well-known reinsurance companies include Swiss Re and Berkshire Hathaway’s General Re
Reinsurance offers multiple benefits to investors over longer investing horizons, including:
- Higher return potential, similar to stocks or high-yield bonds.
- Bond-like return mechanics, but without interest-rate risk or economic sensitivity.
- Diversification benefits due to very low correlation with traditional asset classes.
We use Stone Ridge Reinsurance Risk Premium Interval Fund (SRRIX) to provide exposure to reinsurance in client portfolios.
The biggest benefit of reinsurance is that it has very low correlation with the financial markets. Reinsurance has better years and worse years, but with almost no relation to the performance of stocks or bonds. Natural disasters are unlikely to cause a financial crisis. Not only does that help provide stability, it also provides opportunities to rebalance your investment portfolio to achieve your desired target for each asset class.
We anticipate a long-term average return of about 6% to 8% per year with SRRIX. Since January 2002, the Swiss Re Cat Bond Index has returned 8.0% per year. Since its inception in January 2014, the Stone Ridge Reinsurance Fund has returned 7.8% annualized.
In an extreme loss period when multiple severe catastrophic events occur in the same year, it’s possible the fund could suffer a loss of 50% (not dissimilar to stocks). That type of situation is unlikely, but given our recommendation to invest 5% of your portfolio to reinsurance, such a loss would result in only a 2.5% loss to your total portfolio.
Despite the potential for loss, reinsurance is still expected to reduce portfolio risk over the longer term because it isn’t correlated with the stock and bond market. As we said before, natural disasters have nothing to do with the economic cycles that drive most investments.
While banks have long been facilitators and direct investors in loans, including personal loans, student loans or small business loans, recent technological advances have made it easier for individuals to provide credit to borrowers. Initially known as peer-to-peer lending or marketplace lending, it’s now recognized as alternative lending.
In alternative lending, individual lenders – investors who provide capital – are matched directly with borrowers. An alternative lending platform, such as Lending Club, SoFi or Harmony, provides loan origination, underwriting, servicing and matching between lender and borrower for a fixed fee. Because of the lower overhead structure and the reduced regulatory and reserve requirements, the online lending platforms can simultaneously offer lower interest rates to the borrowers and higher yields to lenders as compared with traditional banks.
The following example shows a comparison of an average borrower with a FICO credit score of 699 who is consolidating debt with Lending Club as opposed to traditional credit cards.
The primary long-term benefits of investing in alternative lending include:
- Higher return potential, similar to high yield corporate bonds, with reduced risk and without correlation to stock or bond market performance.
- Bond-like return mechanics with less interest rate risk due to shorter average duration (a measure of price sensitivity).
We use Stone Ridge Alternative Lending Risk Premium Fund (LENDX), a mutual fund that holds more than 100,000 individual loans. This provides broad diversification across geography, borrowers and loan types.
Overview of Peer-to-Peer Investments
The alternative lending fund invests primarily in three types of loans:
- Consumer loans: Average loan amounts are between $10,000 and $15,000, with a $40,000 maximum. Loans are given only to high-credit-quality borrowers.
- Small business loans: Depending on the type of business, loans may be from $5,000 to $500,000. As with consumer loans, small businesses are screened on several factors, and loans are made only to businesses that exceed underwriting criteria.
- Student Loans: Platforms target high-earning, high-credit-quality borrowers, and provide loans at slightly lower rates than traditional student loans.
Because LENDX offers a broadly diversified portfolio, we feel loans can provide relatively predictable risk and return over the long term.
Loan interest rates are set assuming a certain percentage of loans will default. If the defaults are lower than expected, the corresponding returns will be higher. If defaults are higher than expected, overall returns will be lower.
The most likely scenario to cause a large loss to this asset class is a prolonged period of high unemployment across Europe and the U.S. We estimate the fund could suffer a drawdown of 30% in an extreme loss period. Given our recommendation to invest 5% of your portfolio in LENDX, a loss of this type would result in a loss of 1.5% to the total portfolio.
There’s a saying that the stock market has predicted eight of the last three recessions. The corresponding chart shows annual returns of the S&P 500 from 2007 to 2011.[i] It also shows the effect of credit card charge offs on the return of consumer lending investments. Notice that stocks can move down in anticipation of a recession, but that consumer lending returns decline only after the recession materializes.
We feel alternative lending provides a great diversification benefit because it won’t be impacted by bear markets that are not associated with economic recessions.
We often think of investments in real estate as owning buildings, plots of land or houses. Whether it’s your personal residence or a property you rent out for cash flow, this type of real estate investment is a concentrated holding, though one that can be leveraged quite a bit and provide you big gains. However, the risk of a large decline in value exists whenever you hold a concentrated position of any kind. For most individual investors, diversifying a portfolio of directly owned real estate is a challenge because acquiring real estate has a lot of up-front costs. Also, directly owned real estate is not a liquid investment. It takes significant time and money to convert it into cash.
An alternate way to invest in real estate without these drawbacks is through Real Estate Investment Trusts (REITs). REITs are a collection of commercial or residential properties like shopping centers, office buildings, apartments and hospitals. They’re bundled together and sold as a security like a stock or mutual fund. REITs can allow an individual investor to own a diversified portfolio of real estate holdings without the large cost needed to hold real estate directly. REITs are also much more liquid than directly held real estate.
Taxation of REITs
While REITs are bought and sold in a similar way to stocks and mutual funds, they don’t receive the same tax treatment as those asset types. Whereas stocks and bonds frequently receive preferential tax treatment, REITs don’t get the same treatment. To offset this, we recommend holding REITs in tax-deferred accounts like IRAs or 401(k)s.
Does your portfolio consist of just stocks and bonds? You may be missing out on specialized investments such as reinsurance, alternative lending and real estate. Talk to Merriman to learn more!
The previous post in the series can be found here.
[i] Consumer Loan Charge Off rate data provided by Federal Reserve Bank of St. Louis. The S&P data is provided by Standard & Poor’s Index Services Group.