What Investors Should Know When Investing in Alternative Assets
This week we’re privileged to share the first part of our interview with Dr. Kevin R. Mirabile, C.P.A, D.P.S.
About Professor Kevin R. Mirabile, C.P.A., D.P.S.: Dr. Mirabile is a Clinical Associate Professor of Finance at Fordham University. Prior to becoming an academic, he held senior executive positions at Morgan Stanley and Barclays Capital in banking, trading, and asset management. Dr. Mirabile is the author of several books and oft-quoted articles on hedge funds and alternative investments.
We asked Dr. Mirable his opinion on several alternative investments. Here's what he had to say:
1) By far, the biggest alternative asset class that our clients turn to is real estate. Usually, it is in the form of income producing properties like multi-families. Is this the best choice for a retirement investor or are there other kinds of property investments that may be more suitable?
It’s hard to say what is the best investment choice. Certainly, income-producing properties are important parts of a portfolio because many of the alternative investments that we talk about don't have a cash flow component at all. For example, collectibles, cryptocurrency, and many hedge fund limited partnerships do not have distributions. Having income that can be part of your portfolio construction is important, and if you’re having that income sheltered in a tax-friendly structure like a retirement account, then that's even better because you can defer the taxes on the income component of the property until the overall portfolio is sold or transferred to a beneficiary.
2) Real estate also tends to be expensive for the common investor. This kind of asset can often eat up a large percentage of an individual’s investment capital. Is there a sweet spot in terms of diversification that investors should try to adhere to or is it okay to be somewhat more homogenous in order to get into a property?
There’s a big difference between direct investing in real estate and investing through things like REITs (Real Estate Investment Trusts). Usually, direct investing limits your investment portfolio to one, two, or three properties. If you're a substantial real estate investor, maybe you have 10 properties. It’s often much more efficient for both diversification and risk management to use things like REITs, equity or debt-related or private equity real estate funds. In these cases, a professional accumulates a great number of properties for you, whether they are commercial or residential, and then you are diversified in a thousand properties rather than just the 5 or 10 that you choose to invest in yourself.
Also, the cycle for selling real estate, even in a hot market, takes time. You have to list the property, go through a closing period, make sure the buyer qualifies for a mortgage, etc. It takes time to unwind direct investments, whereas a real estate investment trust trades like equity on the New York stock exchange and can be sold immediately, even though the underlying exposure is to real estate. Also, for many individual investors, their largest personal asset is already their home. That's where a lot of real estate exposure comes from for many individuals - their primary home or their first or second vacation home.
3) Perhaps currently the most exotic of all alternative investments is cryptocurrency. Do you see this as a legitimate contender for long term growth or are there specific factors propping it up right now that suggest it will eventually disappear?
Cryptocurrency is a fascinating space. There are many actors who were propping up the value of a wide range of crypto assets whether it’s Ethereum, Dogecoin, or Bitcoin; most of these assets are being propped up by retail and a handful of committed, institutional players whether it be Elon Musk and Tesla or MetLife and their insurance portfolio. It seems to be a one-way market right now where people are buying and holding, and the asset class is going through a period of intense volatility because as soon as someone decides to not hold any more you see these wild gyrations in price - down 30%, up 30%. A lot of that is because of the usage cases; that's the term that they use, for each of these crypto currencies hasn't been established yet. Everyone is speculating or trading. In other words, Bitcoin’s usage case is a currency replacement as a cryptocurrency. Yet, almost no one uses Bitcoin as currency. So, why does it have so much value?
There are many people who are buying Bitcoin simply as a store of value or as a placeholder. Like the Dogecoin example, it has no stated purpose. This is a very strange thing to me. It’s an asset that has no stated purpose. It is simply a limited number of digitized tokens that you can buy and sell. It can't be used for anything. It can't purchase anything. It can’t represent anything. It was actually created as a joke and now has billions of dollars of market value because people have bought it but have not sold it. All of that kind of activity is going to fall by the wayside, and the legitimate uses of non-fungible tokens, initial coin offerings, and blockchain technology remains to be seen. There's going to be a ton of really viable and valuable usage cases and businesses that come out of this space. The problem is nobody knows which ones they are yet.
Think of it as Netscape. Netscape was to digital music in 2002 - what Apple Music is today. The idea of digital music and online music was extraordinarily successful. But the founder of the first company to offer streaming music crashed and burned in the 2002 .com meltdown. So, I don't think all of these crypto assets will be in place 10 years from now. Many of them will be worthless, but some of them, in fact, will be very valuable and replace a lot of that paper shuffling that's done in the property area, such as Title Insurance and Mortgages. There’s a number of business functions that could benefit from being stored on a blockchain technology and not be recorded in paper files with manual signatures.
4) Your most recent book - Exotic Alternative Investments – covers a lot of the assets that we see investors are currently excited about. For self-directed retirement investors specifically, what do you think they get out of it the most?
There’s a big chunk in the book about financial contracts - things like life settlements, litigation, finance tax liens, and trade claims. These are essentially receivables from someone, whether it's an insurance company or the defendant in a lawsuit who loses. They’re basically fixed-income cash flows that are neither known nor estimable. For example, if a lawsuit settles the verdict will be $1 million dollars payable in two years and the life insurance policy has a billion-dollar face and the person whose life it’s on dies, there’s a cash flow of $1 million to the beneficiary. You can accumulate returns because there's so little money coming into these areas and they're not easily understood. The return on these cash flows can be extraordinarily high - 12%, 15%, or even 25%. Because the cash flows are coming from single-A corporations or AA insurance companies, the risk is like an AA credit.
Go back to your bond days and imagine receiving a high-yield return on an AA bond. These exotic alternative investments are sometimes referred to as specialized credit and private credit. There are managers out there today who are creating portfolios and funds that acquire 1000 life insurance policies and they receive an actuarial pay out and death benefits, but the price they pay for every million dollars at face value is extraordinarily low - perhaps $500,000. You could imagine if it's less than five years to maturity, you're doubling your money and generating a 30% or 40% rate of return.
There are other types of bonds called Pandemic Bonds where the principal is forgone by the investor if a pandemic occurs, and the proceeds are retained. The World Bank and the UN issued these securities so that you get a 20% coupon when there's no Pandemic, but if there's a pandemic, you lose your principal. The proceeds get to be used for vaccines and for other stuff. There are both pros and cons associated with some of these insurance linked securities. Even during COVID, despite the sad and large number of deaths, it doesn’t necessarily change the mortality rates for a portfolio of 10,000 people at age 60 today. Maybe there’s a small percentage that died earlier than planned, but there's also going to be a percentage that lives longer than planned.
5) Where do you see interest rates heading in the next year? Do you think they’ll go up enough to have material impact?
That’s a $64,000 question. Is there going to be inflation and will inflation drive rates higher? Given the large amount of stimulus dollars that are in the system, you would think that inflation would have reared its ugly head sooner. Inflation expectations remain very low and there's a lot of slack in the global economy. In my opinion, it appears that inflation is still being managed to the degree and it's not likely to accelerate beyond the 2%, 3%, or 4% level which would be considered “healthy”. This means that interest rates are not necessarily going to accelerate beyond the 10-year note at the kind of 3%, 4%, or 5 % level it was prior to 2007 at 5%. It’s more likely to see rising rates than falling rates and perhaps the 10-year note goes from 1-6% to 2-5%. That still leaves a long way to go to get to 4 which is the “old normal.” The “new normal” may be in the 2.5-3% range.
I think the answer is rates are more likely to go up than down. The question is, are they going to go up rapidly? I would probably say no. I think rates will just continue to drift higher, but every time there’s a crisis and the Fed decides to step in, the rates come back down. I do think rates are going to go higher over the next three to five years.
6) If something can’t be explained to the average investor, should they stay away from that investment?
There’s something that we call the “Complexity Premium,” which says that if you take the time to investigate why a particular strategy or fund is generating a high return, you can kind of demystify it like I tried to do earlier with those fixed-income insurance linked products, where you're getting $1 million from an AA rated insurance company. When someone dies, why do you generate a 15% return on that? Well, the reason is simply that there are not enough investors who are willing to buy those policies, so you have an imbalance between supply and demand.
I guess my answer would be: if it’s not straightforward and not understandable, it doesn't mean you walk away from it. You can probably do a little more due diligence and then perhaps you'll find that what seemed complex is fairly straightforward. If after digging in and it still doesn't make sense, you should walk away. There's a lot of platforms and companies now that are channeling money into asset-back loans, life insurance products, litigation funding products, and some of the other things I mentioned where the returns are simply there because there’s insufficient investment dollars in the space.
I’ll give you one more example: your local municipality. When there’s someone who doesn't pay their property taxes, the municipality charges a 20% rate of interest inclusive of the penalties for late payments of taxes. They could sell that to an investor who will pay the municipality for every hundred thousand in back taxes. Investors can’t get a 20% return, so they’ll pay $110,000 to the municipality and the municipality is owed only 100,000 taxes. The investor pays $110,000, and they get $120,000 at the end of one year. The $10,000 return on the $110,000 investment has an 8% return.
That's pretty good for most investments. So, that trade makes perfect sense once you demystify the question: why am I earning 8% on these tax liens? The reason is because the municipality is able to charge 20% and they are splitting the profits with you. Ultimately, all the taxes always get paid because the municipality always has the right to force the house into foreclosure and sell the property at pennies on the dollar to pay the taxes. There are very few properties whose market value is not more than the accrued back taxes. It may be more than the mortgage, but it is not more than the accrued back taxes. It's basically back to that proposition again: it's a guaranteed income from a strong, over-collateralized transaction that you're earning 8% on - which is unheard of. There are trades out there where it is seemingly too good to be true and it turns out in fact that it is true and it is very good.
For more about Professor Mirabile, visit his Fordham webpage.
To read his books about hedge funds and exotic investments, click here.