At the depths of the 2008 financial crisis, few would have predicted that we’d soon enter one of the longest-lasting stock market rallies of the modern era. The current bull market, in which stock prices have risen without a 20% pullback, is now more than eight years old, the second-longest such stretch on record.

And for much of that time, the central bank’s monetary stimulus policies have also led to impressive gains in bond prices (while yields have steadily fallen).

But bond yields have backed up over the past year, and the Federal Reserve has plans for further interest rate hikes in coming quarters, which means one leg of the stocks-and-bonds rally has come to an end. And this spring’s Washington-induced stock market volatility could signal headwinds ahead for equities as well.

The best plan of action: diversification. And alternative investments will play two crucial roles in portfolio management. They tend to be non-correlated with stocks and bonds, which means they can smooth out returns. And certain kinds can produce robust income streams at a time that the bond yields on offer are still small. The key question comes down to whether you want the freedom that highly liquid investments bring, or the potentially higher returns and yields that illiquid investments can often offer.


The Liquidity Trap
One type of investment growing in popularity is interval funds. These closed-end products buy high-yielding, low-liquidity investments such as private loans, structured credit, farmland, “catastrophe bonds” or commercial real estate debt—things often owned by private equity and hedge funds. They don’t carry the high minimum investment thresholds that hedge funds do, but they can be redeemed only once per quarter, typically. That constraint, however, is why they are priced to offer fairly robust yields—they side-skirt the “the liquidity premium” of more readily tradeable investments.

Morningstar notes that there are now around 30 interval funds managing around $9 billion in assets, and another 20 funds are in registration.

One example is the PIMCO Flexible Credit Income Fund (PFLEX). The firm says the interval fund approach allows its bond managers to buy debt instruments that would be ill-suited to a more active trading vehicle. Another fund is the Resource Credit Income Fund (RCIAX), which currently yields around 6.6% with very little default or interest rate risk.

Another illiquid option: health-care royalty funds. These acquire the future revenue streams of small drug firms, either public or private, in exchange for up-front capital that doesn’t dilute current shareholders. Royalty funds can yield 15% or more in annual cash flow, net of fees. However, they are typically available only to accredited investors who have either $1 million in investable assets or who brought in $200,000 in income over the previous two years.

HealthCare Royalty Partners and OrbiMed are leading players in this segment, although other firms are planning to move in.

Lastly, investors willing to tolerate a lack of liquidity may want to consider catastrophe bonds, which provide backup insurance to insurers. Stone Ridge Asset Management is the largest “cat bond” placement firm focused on the registered advisor market, with roughly $4.5 billion in assets under management. Cat bond funds typically offer 8% to 10% yields, net of fees, which is very impressive given their low levels of risk, and they boast diverse types of coverage for disasters in different regions.

Better And More Liquid Than A Hedge Fund?
Institutional investors have long sought protection against slumping markets, typically by investing in hedge funds. Such funds adopt distinct approaches, including market neutral, long/short, global macro, event driven and multi-strategy funds.

Yet these funds have some clear drawbacks, including high fees. They also allow less access to non-institutional investors, and they lack liquidity. Still, two types of fund are worth considering: Liquid alternative investments and infrastructure funds. Both provide portfolio diversification while the latter is also known for robust income streams.

To be sure, “liquid alts,” as the hedge-fund style mutual funds are classified, have suffered from an epic level of bad timing.

Liquid alts came into vogue after the market rout of 2008 and early 2009, since they had enjoyed impressive performance in previous periods of market instability, such as those in 1998 and 2000.

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