You know the drill. Investors are always looking at ways to include products in their portfolios with the objective to keep them diversified. Likewise, investment professionals are looking for products to bring to the attention of investors that may help to increase returns for their clients. As markets moved higher last year, investors speculated when the next correction would arrive and factors that would lead to it.
Financial professionals continue to seriously look at active investment strategies to prepare for any potential market shifts. Although there are many different ways to diversify portfolios, the use of alternative investments may help to solve the diversification puzzle.
Specifically, the use of unit investment trusts, variable annuities and non-tradable REITs used in the right manner, and with suitable clients, may help to fill a particular need. Let’s look at each of these alternative use products.
Unit investment trusts (UITs) represent a collection of static stocks or bonds and sometimes a combination of both. They are designed to represent a very targeted and specific investment style and can have a life of 12 months to several years in duration. A UIT investment is represented by one assigned CUSIP number. UITs can be differentiated from a traditional mutual fund whose life is not definite. UITs may look like a regular security, because they are assigned CUSIP codes, much like a stock or bond; however, they are a collection of stocks, so when you look closely, you may think you’re looking at something that looks similar to a mutual fund. There are equity (stock) trusts and fixed-income (bond) trusts. They are offered in any flavor of target markets you may be looking for. For example, there are trusts that represent common themes such as global large-cap companies, high-dividend-yielding companies or even country-specific stocks. There is literally a trust for any sector missing in your client’s portfolio.
UITs enable a client to own a basket of securities with one single purchase, rather than trying to select individual stocks or bonds that meet specific objectives. UITs are built to suit many different types of investment needs, objectives, risk tolerances and even investment horizons. They can save a financial professional a lot of time in selecting just the right slice of investment that could enhance diversification within a portfolio, and they can track performance using just one ticker symbol.
An investment in an unmanaged unit investment trust that is based on specific strategies carries certain risks associated with owning common stocks, including the risk that the financial condition of the issuers of the stocks or the general condition of the stock market may decline. The value of the securities held by a trust may reflect steep declines or increased volatility due to changes in market performance. Since UITs operate similarly to a closed-end mutual fund, the cost of the UIT is priced at the initial public offering per unit cost, usually at $10 per unit. Regarding redemptions, UITs can be redeemed anytime during the trading day within the defined life of the UIT, either at, above or below current NAV. Most UITs have reinvestment options that allow an investor to roll over distributions on a “matured UIT” into another UIT with reduced sales charges. The costs could include a small percentage up front, say 1% with a different percentage taken over a number of deferred months—for example, 2.45% taken over months four, five and six, along with a onetime fee of 0.50%.
The next type of alternative investment is variable annuities. Literally, the evolution of these products has taken a 90 degree turn. About 10 years ago, a variable annuity was a product that allowed clients to build growth into their portfolio. Today, variable annuities take on many very different profiles and financial advisors should seriously consider many different variations of the annuity profile in search of the right solution for their client. The annuity companies went through a very tough economic time with the advent of the stock market crisis, and with it, many companies discontinued offering variable annuities due to implied risk valuations assumed by the annuity companies. As the U.S. economy continues to recover from the financial crisis, even at a modest pace, annuity companies are attempting to offer more value to the client by coming up with different variables to offer within annuity profiles. For example, if a client seeks a managed risk and tax-advantaged investment and needs income for life, either with or without regard to death benefits, or if a client just wants an annuity that is similar to a robust mutual fund platform with the choice to annuitize later on in life with trading flexibility, be assured these and other choices seem endless.
Annuity companies seem to offer all types of products that may be applicable to a number of different types of circumstances. A variety of investment options, a shorter surrender schedule, a number of living benefit options, a number of death benefit options—so many choices. A financial professional should ensure that a thorough understanding of the options are fully digested in order to recommend the most suitable product profile for their clients.
Lastly, the non-traded REIT space has proved to be a popular alternative investment for professionals seeking to apply more diversification into client portfolios. These products offer an increased return of interest paid out in the form of reinvestment at below NAV share cost. One of the ways the financial crisis introduced risk to clients was that some non-traded REITs tied up investors’ capital for a long time and without an exit strategy. As a result, non-tradable REITs are under review by Finra.
Finra is also reviewing cost transparency to clients. For example, a per share cost is generally $10 per share; the clients’ cost is reflected at $10 per share, for example, when the true cost also includes a commission fee that is paid by the sponsor, but the client statement shows $10 per share cost. Investment professionals can expect that Finra will be working to develop new rules regarding transparency of valuation disclosures. With the advent of increased interest rates, sponsors of these products will be limited with the reduced cost of borrowing money with lower interest rates. Financial professionals must be diligent in determining whether an investor is suitable for this product. Investors are limited on the percentage of ownership as it relates to net worth as well as liquid net worth, along with limited transferability of shares among REIT owners, and, finally, different states have different limitations regarding ownership.
As already mentioned, risks are as high from the investor viewpoint as from the sponsor’s viewpoint. Sponsors may face conflicts of interest because a certain few officers could be managing several REIT properties at one time. A conflict of time spent by certain officers on a certain REIT program may create an unbalanced concentration of management, thus a REIT program’s performance may suffer as a consequence. Investors may eventually experience a liquidity event from one REIT and roll capital back into a different REIT program, which may create a competitive environment for investors among different programs of sponsorship.
Among the volatile investment community, investors and financial professionals alike share the vision to step away from the ordinary traditional investment vehicles and seek to include a portion of some variation of alternative investments into their client annual planning meetings to help diversify portfolios and shield portfolios from volatility while still reaching for return. The alternative investments described in this article are intended only for use by suitable investors. These investments carry costs, and thus it is the responsibility of the financial professional to explain the investment products’ advantages and disadvantages and ensure that the client understands fully what they are about to invest in.
Emily Domingue is a registered representative in Baton Rouge, La., for JHS Capital Advisors.