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At Intercontinental, one of our main duties as asset allocators is to explore the vast universe of asset classes, securities, strategies, and investment vehicles available to us, as well as understand their risk profile and return potential. Consider a chef: a broader and more detailed knowledge of the ingredient universe provides for a much richer menu of potential combinations and outcomes.

Although all investment securities fall within the basic capital structure of entities (equity and debt), their ultimate risk-return profile is dictated by the market in which they are a part of, and the factors that dictate such market. We can all agree that not all equity and not all debt is created equally. As an example, we should expect completely different return and risk dynamics for a publicly registered subordinated piece of debt from a large cap capital intensive US company than for a non-registered subordinated debt from a medium size US capital-light business. Liquidity, earnings stability, collateral value, profile of subordination, and the composition of the debt indenture are some of the factors that would determine how the two debt securities behave relative to macro conditions, and therefore relative to each other. Understanding the main factors that drive each asset class, and how these factors respond to macroeconomic changes, is critical to the construction of our menu of portfolios.

In our exploration of the investable universe, we have stumbled across a few asset classes and strategies that have become excellent additions to the usual portfolio of public equities and public fixed income securities. We take this opportunity to share some of these investment opportunities with you, the reasons why we believe they merit allocation in our clients’ portfolios, and the importance of experienced analysis for their selection.

1) Private-Registered Core Diversified Equity Real Estate Income Trusts (REITs):

Often compared to their publicly traded counterparts, non-traded REITs can offer very interesting attributes. We favor diversified REITs with institutional management teams. A “diversified” mandate allows managers the flexibility to invest in markets that offer the most opportunity. In real estate, there is always a myriad of investment opportunities. Clients are routinely exposed to small, concentrated private deals from real estate managers that deem to be experts of a certain market or asset class. 

Investors should be weary of feeling a false sense of comfort in some of these investments sheerly because they can engage in on-site visits and may have a direct  “pick-up-the-phone” relationship with the asset manager. More times than not, it makes sense to invest through an institutional fund that has better sourcing networks, the heft of management tenure, and proper negotiating expertise for favorable terms of financing, contract construction and asset management, to mention a few key points. We are attracted to diversified Equity REIT funds because they can provide very attractive after-tax inflation protected yields, as well as capital appreciation opportunities with low correlations to equity markets.

2) Private-Registered Mortgage REITs:  

Another interesting asset within the real estate market is mortgage REITs, often known as credit REITs. Market participants might be familiar with publicly registered Mortgage REITs but have often not explored their private counterparts. Mortgage REITs may vary significantly in their portfolio composition, debt management, and operational terms. Lack of correlation to equity markets, diverse funding sources, and often more diversified asset pools are some of the main advantages that characterize these low volatility yield plays. These vehicles can offer very attractive yields, often comparable to publicly traded HY paper, yet with significantly higher collateral coverage. As with Private Equity REITs, we prefer portfolios run by institutional managers.

3) Direct Lending Private Credit Registered BDCs:

Private Credit has seen explosive growth this last decade. The implementation of Basel regulations forced many commercial banks to exit non-primary lending markets, and in particular, those lines of business that forced higher reserve requirements. 

Opportunistic institutions were quick to set up private credit teams with the goal of capturing opportunities once dominated by banks. Direct Lending to middle market private companies was one of the prime fertile opportunity sets. As with real estate, a lot of small teams with questionable expertise flocked to the space to capture yield-hungry investors. 

Private Credit is a game where strong fundamental analysis and legal expertise is critical in drafting debt agreements with positively skewed outcomes. It is always advisable to enter the space with a manager that has shown experience in credit agreements and that has an attractive sourcing network. 

With the right partner, this space offers the potential of floating rate loans with high single digit returns, solid collateral, and lower default ratios than subordinated publicly traded paper. 

4) Secondary Private Equity Funds:

Although limited to Accredited Investors and Qualified Purchasers, private equity funds are a very attractive way to get niche equity opportunities that are different from those offered by public markets. Within private equity funds, there is a sub-set category called secondaries which essentially buys ownership of funds from limited partners that need liquidity. These secondary transactions usually trade at a discount to NAV, and unlike a primary participation, provide longer insight into portfolio holdings and their performance. There are several well-renowned institutional firms that offer secondary platforms in various vehicle forms. 

5) Managed Future Strategies:

The key to diversification is to find strategies with unique risk profiles that ideally do not correlate at times of risk-off environments. The famous 60% equities-40% treasuries strategy is a simple attempt to create a portfolio that holds up at times of equity sell-offs. The potential stability of this strategy however is highly compromised when interest rates are low and nominal interest rates have a higher potential to be positively correlated with equities.

This is exactly the type of environment we have faced post the great financial crisis. Strategies with very low correlation to the main asset classes become even more valuable at this juncture. Managed Futures is an acronym for a quant driven investment strategy that often uses future markets to implement their investment calls. These managed future portfolios are often varied flavors of momentum-driven strategies that attempt to provide positive returns in both risk on and risk off environments. Institutional managers enjoy platform advantages that provide lower trading costs, and quicker execution which can translate to better net returns.

There are a number of well-renowned institutional firms that offer Managed Future strategies in various vehicle forms. Contact an Investment Advisory firm with experience in Alternatives to help you navigate the opportunity.

If you have any questions on investing in any of these opportunities outside of the market, please don’t hesitate to contact us

JP Villamarin, CFA, CAIA
Senior Investment Analyst at Intercontinental Wealth Advisors