Once again, we’re seeing extreme volatility in the stock and bond markets. Investors are worried about their portfolios. Locally, the stock prices of two companies that have been longtime stable giants for many investors – Washington Mutual and Starbucks – have collapsed before our eyes.
What’s an individual investor to do? Let’s turn for a minute to the lessons offered by institutional investors. These are those large organizations that manage significant sums of money for large institutions – colleges and universities, banks, insurance companies, retirement funds, pension funds, non-profit organizations, etc. Like individual investors, they can’t afford to lose money – and their stakeholders don’t have the patience for extreme volatility.
While they are faced with the same market forces as individuals, many institutional investors do much better. If we look at investment returns from 1988 through 2007, the S&P 500 returned an average of 11.81 percent per year, compared to only 4.48 percent per year for the average equity investor. This is even more disturbing for individual investors looking toward retirement. While average returns may be acceptable, we all know that average means little when the returns that make up the average happen to be at the low end of the cycle in years that we want to get out.
Back to institutional investors: For that same time period from 1988 through 2007, most routinely saw a 15 percent per year return. Perhaps the most famous institutional investor – the Yale University Endowment Fund, run by famed fund manager David Swensen – generated an annual compound growth rate of 16.3 percent.
How do they do this? The answer is simple: They have rejected the time honored traditional investment allocation made up almost exclusively of stocks, bonds and T-bills. They have adopted, if not pioneered, what I call the modern asset allocation model, one that makes extensive use of “alternative investments.” Yale’s asset mix includes only 16 percent in U.S. stocks and bonds, with the remaining 84 percent in foreign equity, private equity, and other alternative investments.
These non-traditional investments include hard assets, such as real estate, that aren’t tied to the equity markets and generally move independently of inflation and recession. That stability of the alternative investments serves to reduce the volatility of the overall portfolio. For example, annual studies by Morningstar and Ibbotson Associates have consistently shown that the addition of commercial real estate to a traditional portfolio of stocks, bonds and T-bills may increase the return of the overall portfolio, while, at the same time, reducing the risk.
According to recent studies, including one by Harvard Business School, the majority of university endowment funds with more than $1 billion in assets have only a 21 percent allocation of standard equities and 12 percent in fixed income. At the same time, they allocate an eye-opening 46 percent to alternative investments, with the rest in cash and other forms of liquid assets.
It’s true that billion-dollar institutions have access to some investments that aren’t available to individual investors. However, the bulk of their alternative investments are the same types of hard assets available to individual investors – even those without seven-figure portfolios or six-figure incomes. Individuals can invest in the same options that institutional investors do. These include such direct investments as non-traded REITs (real estate investment trusts), energy exploration-and-development limited partnerships, and equipment leasing corporations.
Individuals who invest in tangible or hard assets such as these own a share of the actual assets of an operating company and may benefit from the assets’ value, such as the income they produce. For example, investors who invest in a non-traded REIT own part of the real estate holdings of the REIT. While past performance is not an indication of future results, returns have been excellent. A 2007 study by Robert A. Stanger & Co. found that on average, the typical investor in such non-traded REITs received a full return of his or her capital investment plus a combined gain (ongoing dividends plus liquidation proceeds) of an additional 64 percent during an average holding period of five years. Internal rates of return averaged 12.5 percent; 13.6 percent for those investors who reinvested their dividends. It was during this same period that publicly-traded REITs went from the best performing asset class on Wall Street in 2006 to the worst performing in 2007. Now, that’s volatility!
Investors who invest in an equipment leasing corporation own part of the actual equipment offered for lease by the corporation. Those who invest in an oil development corporation own part of the corporation’s wells and the proceeds of oil sales. In addition to producing income, such investments also provide many tax benefits, including depreciation and operating costs.
Opportunities to invest come via a registered investment advisor or a registered representative of a broker-dealer. These are considered long-term holdings (four to 10 years) and are generally illiquid, however, many have redemptions options that may include penalties. As with any investment, these opportunities carry their own risks and investors should consider investment objectives, risks, charges and expenses carefully before investing.
This isn’t investing with your brother-in-law or in a private fund that your neighbor has put together. These are programs with national companies with long-term records. And they’re options that the large institutional investors use to hedge against the severe volatility of the stock and bond markets – volatility that we’re in the throes of today.
