Large institutional investors and high-net-worth individuals have helped advance a new asset allocation model — one that introduces alternative investments to provide diversification and potential protection against rising inflation. While institutions have different goals and longer investment horizons, individual investors seeking similar benefits may choose to access alternative investments via non-traded direct participation programs, such as real estate investment trusts (REITs) and business development companies (BDCs).
The traditional model of allocating investments to stocks, bonds and cash is widely available to individual investors. While diversification can occur within the traded markets, institutional and high-net-worth investors often leverage their wealth in search of diversification beyond traded investments and for returns from alternative assets and strategies. In doing so, these investors have helped advance a new allocation model that now includes illiquid and less liquid alternative investments. This model is increasingly available to retail investors.
The term alternative investments refers to nontraditional investments that fall outside the common categories of stocks, bonds and cash. Some examples include real estate, loans made to private companies (private debt), private equity, infrastructure and energy investments.
Institutions often invest under terms and conditions different from individual investors, particularly with regard to fees and expenses. That said, typically the alternative investments in institutional portfolios have performed well. The Yale and Harvard endowments are two examples of this strategy in action. While allocations can vary widely between institutions, both portfolios contain a relatively high percentage of alternative, illiquid and less liquid assets. Though the inclusion of alternatives is only one factor in each endowment's overall strategy, and past performance is no guarantee of future results, 10-year historical investment returns have been strong compared to a more traditional portfolio consisting of 60 percent stocks and 40 percent bonds.
Non-traded alternatives may offer several potential benefits to an investor's portfolio, such as diversification, lower correlation, reduced portfolio volatility and an opportunity for inflation protection.
Low Correlation: The cornerstone of portfolio diversification is the inclusion of low-correlated assets. If asset values have low correlation — or values that do not lockstep in response to market changes — the portfolio's overall value is less affected by movements in any one investment.
Reduced Volatility: Another potential benefit is reduced portfolio volatility4. For investors looking to mitigate some of the price swings of the stock market, alternative investments are worth consideration. Historically, less liquid alternative assets such as real estate and private credit have been less prone to the wide price swings seen in traded domestic and international stocks.
Potential Inflation Protection: Lastly, alternative investments may serve as a way to mitigate inflation risk. During historical periods of high inflation, hard assets have typically performed well. In addition, alternative debt instruments may have floating rates, thus allowing interest-based income to increase as interest rates rise in response to inflation concerns. However, if interest rates do not rise or if they fall, then interest-based income derived from such investments would be reduced, perhaps significantly.
Past performance is no guarantee of future results.
1 Congressional Report, Yale Office of the President, April 1, 2016.
2 Congressional Report, Harvard University Office the President, March 31, 2016.
3 CITI Big Index, accessed on Aug. 12, 2016.
4 An investment's price stability does not indicate stability in the value of the underlying assets, which will fluctuate and may be worth more or less than the investor initially paid. An investor may not be able to sell shares of a non-traded investment.
In the past, access to alternative investments was limited to institutional or high-net-worth investors, because direct ownership of alternative assets, such as a multimillion dollar commercial real estate property, can be costly. Considerable knowledge is often needed to navigate complex markets or industries. Plus, the management of alternative assets typically requires significant time and resources. Alternative investment vehicles such as non-traded REITs and non-traded BDCs may provide retail investors with indirect access to asset classes such as commercial real estate and private credit.
Non-traded REITs and non-traded BDCs pool investors' capital to make an investment — REITs in real estate and BDCs in the debt or equity of private companies. The non-traded REIT or non-traded BDC receives income in the form of earnings or interest payments. This taxable income is then passed along to the investor in the form of distributions. Non-traded REITs, and non-traded BDCs if organized as a regulated investment company (RIC), must distribute at least 90 percent of their taxable income to avoid certain corporate income taxes. Both structures have similar transparency and tax treatments. With that said, even if a non-traded BDC does not pay 90 percent of its income, it still qualifies as a BDC but loses its RIC status.5
5 If the investment portfolio is unable to meet the required qualifications regulated investment company (RIC),
it must begin paying additional corporate income taxes on a federal level, which would reduce distributions paid to stockholders.
6 If the BDC is registered as a RIC.
Despite the potential benefits, the inclusion of non-traded alternative investments in a portfolio may provide a high degree of risk. These risks include:
Limited Liquidity: Non-traded alternatives offer limited liquidity, and liquidations may be less than the original amount invested. Their redemption plans are generally subject to suspension, modification and termination at any time. Early liquidation is also often at a discount to the current share price.
Complex and Difficult to Evaluate: Non-traded alternative investments may be more complex than traditional investments, and a potential lack of independent ratings may make them more difficult to evaluate.
Values Can Fluctuate: The values of non-traded alternative investments can move up or down, with
valuations occurring less frequently than traditional investments. In the case of non-traded REITs, valuations are infrequent and, therefore, maintain the established purchase price as the share price until the portfolio is valued. However, this is not to be interpreted as evidence of a stable asset value; these values will fluctuate and may be worth less than the original purchase price. During the initial offering period, the investment's lack of transparency regarding its share price can present challenges to finding a market in which investors can sell their shares.
Furthermore, some alternatives have a limited operating history and a higher degree of risk, and pay substantial fees and expenses to the advisor, affiliates and financial representatives during their offering, operations and liquidation or listing, which could result in significant conflicts of interest.
As a result, non-traded REITs and non-traded BDCs are not suitable for all investors. Suitability standards can be found in the offering's prospectus. Investors should consult a financial professional to determine whether risks associated with an investment are compatible with their investment objectives.
Alternative investments such as non-traded REITs and non-traded BDCs may provide unique advantages. As access to alternative investments continues to expand beyond high-net-worth and institutional investors, individuals are poised to potentially benefit from the diversification, lower correlation, reduced portfolio volatility and potential inflation protection that alternative investments can bring.
This information is provided only as a summary of complicated topics and does not constitute legal, tax, investment or other professional advice on any subject matter. Further, the information is not all-inclusive and should not be relied upon as such. You should not use this information as a substitute for your own judgment and you should consult professional advisors before making any investment decisions.
This is not an offer. Securities can be offered by the prospectus only. Investing in non-traded business development companies (BDCs) and non-traded real estate investment trusts (REITs) is not suitable for all investors; the prospectus should be read carefully before investing. The prospectus, which is available at sec.gov, and cnlsecurities.com and may be obtained by calling 866-650-0650, contains this and other information about the investment offering.
An investment in Corporate Capital Trust II and CNL Healthcare Properties II is illiquid, which means there is a limited ability to sell shares. The share redemption and/or repurchase plans are subject to modification, suspension or termination at any time.
CNL's newly formed investment programs are subject to all of the business risks and uncertainties associated with any business that has a limited operating history.
There is no assurance that each of the company's objectives will be met.
There is no guarantee of future cash distributions or if distributions will be paid at all. Due to the high levels of investment costs and fees incurred during the BDC's and REIT's initial phase, distributions will not be fully covered by cash flows from operating activities and will be paid from expense waivers, borrowings and offering proceeds, which is not sustainable over the long term and may reduce investors' return. Future distributions may also be paid partially from sources other than cash from operations.
Both Corporate Capital Trust II and CNL Healthcare Properties II are obligated to pay substantial fees to their advisor and their respective affiliates for their services. The fees are payable based on factors other than the quality of services and could influence their advice and judgment.
If the BDC or REIT fail to maintain their qualification as a RIC or REIT for any taxable year, it will be subject to federal income tax and net earnings available for investment or distributions would be reduced.
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