It’s long been understood that holding alternative assets as part of a diversified retirement portfolio is a benefit to any investor. When used appropriately, non-traditional assets such as real estate, private equity and hedge funds can improve portfolio diversification, enhance risk-adjusted returns and broaden the set of investment opportunities. Many alternative assets have low correlations with traditional investments, making them effective tools for reducing portfolio volatility.  A study by investment research firm Robert W. Baird noted that replacing 20% of a traditional stock and bond portfolio with alternative assets cut volatility by 10% while also increasing returns, even after taking into account added fees and expenses.

Some investors mistakenly think about alternative assets as a single asset class, but this can lead to poor choices, since each alternative asset is designed with a specific purpose and to deliver a unique set of benefits. The risk/reward trade-off of each must be weighed separately to select a product compatible with the investor’s financial objectives, liquidity requirements and risk tolerance.

Mortgage Pools - Why These Funds are Great Alternative Investments

But not all alternative assets are created equal—the average investor may suffer if they invest in a hedge fund focused on difficult-to-understand investments.

Alternative assets employing complex or opaque investment strategies may be poor choices for the average investor. This is an issue with some hedge funds, which employ tools such as forward contracts, swaps, options, derivatives and features that can leave even the most sophisticated of investors confused. An average investor makes a huge leap of faith when buying these products, betting that a smart hedge fund manager will also have a market-beating strategy.

The flaws in this thinking were demonstrated by Long-Term Capital Management, a prominent hedge fund from the 1990s managed by two Nobel Prize winners that nonetheless lost billions of dollars for its investors. The odds remain stacked against the average investor. In 2015, the 20 most profitable hedge funds earned $15 billion, while the rest of the industry lost $99 billion.

Other drawbacks of hedge funds are ultra-high investment minimums, lengthy lock-out periods and hefty management fees. Hedge funds are known for their 2/20 fee structure—managers typically take 2% annual fees plus 20% of fund profits. This type of fee structure may actually encourage managers to make riskier bets that maximize their fees. Another issue is that hedge funds aren’t subject to the same regulatory scrutiny as other investments. Investors may find it difficult to evaluate the fund’s holdings or performance.

Another alternative asset poorly suited for average investors is private equity, which owns stakes in business turnarounds and start-ups. The primary advantage of private equity is the scope of the opportunity. Privately-held companies make up roughly 95% of the market. A key disadvantage is the relatively short lifespan of these investments. The typical private equity fund lasts just ten years. Another drawback is their limited liquidity. Investors must commit large sums (usually $100,000+) and are usually precluded from withdrawing capital for up to ten years. There is also risk that fund assets are priced inefficiently. Valuing turnarounds and start-ups is an inexact science and investors won’t know if fund assets were valued correctly until years later, when the fund is liquidated and its asset are spun-off or sold.

Real estate is one of the most desirable alternative assets, and mortgage pools offer a means of enjoying the benefits of real estate investment, without the costs of ownership.

Real estate remains the most popular alternative asset. Real estate provides low correlation with stocks and bonds, a tangible value and an enormous set of investable opportunities. Direct property ownership isn’t desirable for the average investor, however, due to high transaction costs and property management fees. Properties are costly to operate and require ongoing maintenance.

Because of the transactions costs, few investors can afford to own multiple properties. Owning a single property concentrates risks. The cyclicality of real estate markets can also result in sub-par investment results for multiple years.

While not widely known, mortgage pool funds have characteristics that should appeal to everyday investors. These funds provide portfolio diversification, have simple strategies and deliver income, liquidity, and transparency superior to many other alternative asset classes.

A mortgage pool fund is created from a pool of real estate loans owned collectively by the fund’s investors. Most mortgage pool funds have hundreds of mortgage loans or trust deeds in their portfolio. These loans are diversified geographically and by size and property type. A trust deed is similar to a mortgage, but has the advantage of allowing lenders to foreclose on the property without going through a judicial process. Risk is minimized by holding only first lien trust deeds, which have priority over all other claims on the property.

Unlike complex hedge fund strategies, mortgage pool funds generate income from straightforward fix-and-flip loans. These loans are made to real estate professionals who need funding to acquire, renovate and market properties. Unlike private equity, which can take years to deliver results, the results of a property flip are known within a few months. Most fix-and-flip loans have one to three-year terms. Mortgage pool fund are shielded from losses on unsuccessful flips by underwriting criteria that limits loan to 70% or less of property value. If the loan defaults, the mortgage pool fund can recover principal and interest by re-selling the property. Since the property’s value exceeds the loan amount, investors shouldn’t lose money even in a foreclosure.

Mortgage pools are a critical means of insulating your investment portfolio from common forms of risk, such as volatility, inflation, and rising interest rates.

Owning mortgage pool funds can bring diversification as well as high risk-adjusted returns to a portfolio. This is because mortgage pool funds combine the reliability of a fixed income product with the diversification benefits of real estate, which helps insulate investors from these common risks:

Volatility. Due to a low correlation with stocks and bonds, mortgage pool funds may help reduce portfolio volatility. These funds provide real estate exposure and real estate has been shown to have a very low correlation with stocks. In 14 of the last 15 stock market corrections, real estate prices rose when stock market prices dropped, according to this Barron’s story. The benefits of owning real estate are also demonstrated by the NCREIF property index, which has produced 8.8% annual returns over the last 15 years, far exceeding the 6-7% annual returns of the S&P 500 over the same period.

In addition, diversification within the mortgage pool fund portfolio mitigates unsystematic risk. The pool’s loans are varied by maturity date, geography and property type. As a result, mortgage pool funds are much less volatile than direct property ownership or crowd funding deals, which typically invest in only a few properties.

Inflation. As an asset class, real estate has also proven itself to be an effective hedge against inflation. A TIAA-CREF study showed that, real estate returns move in concert with inflation over the short-term and outpace inflation over the long-term. According to TIAA-CREF, real estate outperformed inflation 83% of the time and produced an excess return over the inflation rate averaging 7%. Real estate’s correlation with inflation is much higher than the stock market’s correlation with inflation, which is why stocks are considered a weak short-term inflation hedge. Bonds are even worse, with returns typically declining as inflation rises.

Real estate’s usefulness as a hedge against inflation is due to the way property leases are structured. Short-term leases allow frequent rent increases and long-term leases usually contain rent escalation clauses tied to annual inflation. In addition, property values keep pace with inflation since rising rents equate to increased property cash flows, which enhances real estate values.

Interest rates. Compared to other fixed income assets, mortgage pool funds are far less sensitive to interest rates changes. This is a result of their short terms to maturity. A typical mortgage pool loan matures in one to three years. Short maturities mean that loan value doesn’t change appreciably when interest rates rise since capital from maturing loans is quickly rolled back into new loans bearing higher interest rates.

Another factor shielding mortgage pool funds from rising interest rates is a strengthening economy. Higher rates usually signal economic expansion. Robust economic growth benefits mortgage pool funds by creating new lending opportunities that fuel asset growth.

Mortgage pool funds are a worry-free means for the investor to enjoy a monthly return on their investment.

While direct property ownership often involves considerable time and effort, mortgage pool funds are professionally managed. The role of the investor is to cash their distribution checks. Mortgage pool funds are designed to deliver predictable monthly income and most also give investors the option of re-investing distributions into the pool to expand their investment.

In fact, for established mortgage pool funds, the best measure of performance is the fund’s historical record, especially during periods of economic correction or recession. For start-up funds, investors should evaluate the experience of the fund sponsor, both in real estate and lending. It should be noted that on the other end of the spectrum, very large mortgage pool funds tend to produce mediocre returns because these funds have too much capital to invest and not enough profitable opportunities. Thus, it’s often advisable to go to the effort of researching and investing with a smaller mortgage pool fund to produce robust returns and superior risk-adjusted performance.

One key metric to consider when evaluating mortgage pools is how efficiently they make use of investor capital. Due to their size and complexity, the larger mortgage pool funds often have significant amounts of capital tied up in management compensation and administration. These funds generate average returns while charging fees commensurate with top-tier performance.

Socotra Capital’s fund managers have intentionally kept overhead low in the administration of our funds, which is why on average 97% of the capital committed to our funds by investors is earning interest at any given time.

But how do mortgage pools perform compared to other popular types of monthly income-producing investments?

There has been significant concern among retirees and those planning for retirement when it comes to Investing with the goal of creating steady income for retirement, especially when interest rates are still relatively low. The good news for investors is that there is an expanding universe of income-producing products to choose from. But, how they compare to mortgage pool funds?

US Government Bonds. Investors can lock in reliable income by owning US government bonds or CDs, although the returns on these assets are close to multi-year lows.  At present, 12-month CD yields are below 1%, five-year Treasury yields are approximately 2% and ten-year Treasuries yield 2.5%. Despite a reputation as very safe investments, government bonds have a poor track record of keeping ahead of inflation. With inflation averaging 3% a year over the past century, an investor who held a bond that yields 2% would have lost significant purchasing power.

Despite the Federal Reserve signaling multiple interest rate hikes this year, actions likely to re-kindle inflation, as noted in this Kiplinger article, at today’s prices Treasuries still aren’t pricing in inflation. The last time ten-year Treasury yields were this low was during the Great Depression. Holding a longer-term Treasury in an inflationary environment creates the risk of being locked into below-market rates or forced to sell at a loss to move capital into better-yielding assets.

REITS. Many income-hungry investors have turned to Real Estate Investment Trusts (REITs) to boost portfolio yield. REITs are pass-through investments that operate under special tax rules requiring the majority of their earnings to be paid out to investors as dividends. Unlike US government bonds, over the long-term REIT shares have usually kept pace with inflation.

At present, equity REIT yields are attractive at 3.9%, or nearly double the S&P 2.0% dividend yield. However, REIT dividends haven’t always been reliable. As noted in this Forbes article, 78 REITs cut or suspended dividends during the 2008 financial crisis. REITs also face several near-term challenges. Even a modest slowdown in the housing market may hurt their ability to increase rents, their principal source of income growth. In addition, many retail REITs are struggling as competition from on-line retailers has slowed shopping center traffic to a trickle. Some financial advisors argue that REITs are already overvalued; in the last five years, the S&P U.S. REIT index has risen by nearly 60%.

BDCs. Yields on Business Development Corporations (BDCs) are attractive, with many BDCs yielding upward of 10%, but several factors make this sector somewhat risky.  Depending on the BDC, a large portion of the portfolio may consist of mezzanine debt that is illiquid, unsecured and subordinated. In addition, about 10% of BDCs invest in risky private equity securities. BDC managers typically leverage their portfolios, often lending $1.5 for every $1 of capital held. Dilution risk is often high since equity raises are needed to bring in new capital. During the Recession, several BDCs nearly folded and virtually all BDCs cut or suspended dividends. Approximately one-quarter of BDCs cut their dividends in 2016.

MLPs. Master Limited Partnerships (MLPs) are popular with income investors due to generous yields often exceeding 5%. However, most MLPs are primarily involved with the energy sector. MLPs own pipelines, oil and gas storage facilities and exploration and production businesses. Declines in energy prices often reduce dividends and share prices in this sector. Most MLPs must borrow money or issue new shares to grow their operations and cash flow. Many MLPs also have substantial debt loads, which will often cause cost of capital to rise as interest rates climb.

Other Types of High-Dividend Stocks. Shares in public utilities are often referred to as “widow and orphan” stocks due to their lack of volatility and rich dividends. Yields on utility stocks currently range from 3% to 5%. A major disadvantage of utility stocks, however, is their limited growth potential. Most utilities are regulated, which means that rate increases must be approved by government regulators. Rate increases are generally modest. As a result, dividend growth for utility stocks averages only around 2-3% per year and price gains over time tend to be minimal.

When compared to bonds and dividend-paying stocks, mortgage pool funds have several characteristics that make them attractive income investments.

Mortgage pools are an attractive alternative investment, as their safety profile can be adapted to meet the investor’s appetite for risk.

Risk-adverse investors should look for a mortgage pool fund that is low risk. The riskiness of a fund can be judged by its underwriting criteria, which is usually described in the fund prospectus. Two key determinants of risk are the loan-to-value ratio and the lien position on the trust deeds (i.e. trust deeds can be first lien or second lien). If income and preservation of capital are your goals, pick a fund that has conservative underwriting criteria. A fund that consistently delivers good returns is preferable to one that swings for the fences for huge returns but often misses. Very aggressive fund strategies can backfire badly if real estate markets turn unexpectedly.

For most mortgage pool funds, a loan-to-value ratio of 70% is considered conservative. This means that the amount of the loan cannot exceed 70% of the property’s value. The difference between the loan and property value creates a safety cushion that protects investors from losses in the event of a borrower default that triggers a foreclosure and sale.

The lien position of the fund’s trust deeds is important because the highest priority trust deeds (first lien) have the most senior claim on the proceeds from a property foreclosure sale. Second lien trust deeds offer slightly higher returns, but significantly more risk. The Socotra Fund invests only in first lien trust deeds.

Other factors to consider are the fund’s geographic focus, liquidity and management’s ownership stake. Geographic focus is worth noting because yields vary across regions. A very large mortgage pool fund may need to invest nationwide to find enough profitable opportunities, but smaller funds can concentrate their lending in the most profitable niche markets. We currently prefer to target loans in California and Nevada—though we are in the process of broadening our horizons—because their foreclosure rules favor lenders.

One of the most critical advantages of mortgage pools over other alternative investments is the sheer number of regulations which compel full transparency.

Mortgage pool funds must comply with the rules of various state and federal government agencies, which are described in their disclosure documents. The principal document is the offering memorandum, which contains information regarding the fund’s structure and objectives, management team experience and the fund’s historic operating performance. Disclosure requirements for mortgage pool funds are much more rigorous than those of crowd funding deals, which may offer little information about a project’s management team or the track record of the project developer.

In addition, subscribers to mortgage pool funds often have greater access to the fund’s senior management than do public company shareholders or bondholders. This is the result of how funds are structured. Most mortgage pool funds have fewer than 100 subscribers, making it easier for fund executives to respond to individual investor inquiries.

Mortgage pool funds can be a great vehicle for capturing the diversification benefits of real estate without the drawbacks of direct property ownership. An added benefit is that many funds pay dividends monthly, thus providing reliable income, Subscribers can also increase their fund holdings through automatic reinvesting. Fund liquidity concerns are addressed by making shares redeemable on reasonable notice. Most mortgage pool funds are also IRA and/or rollover qualified, making them suitable holdings for retirement accounts.

However, investors must take care in evaluating disclosure documents issued by mortgage pool managers for potential risk factors, such as lock-out periods.

Liquidity can be a concern for investors, as some funds have a two to five-year lock-out period during which investors cannot redeem capital.

The limited liquidity of many alternative assets may pose a problem for average investors, who sometimes need funds for the unexpected or emergencies. Mortgage pool funds address this issue by enabling investors under certain circumstances to redeem all or a portion of their investment at a time of their choosing. Liquidity policies vary across funds, and start-up funds often have lock-out provisions in their early years, so investors must do their homework first by reading the liquidity policy outlined in the fund’s offering memorandum.

This is why it’s wise to seek out funds with no lock-out periods, and where the management’s interests are aligned with shareholders by a large ownership stake. Ideally, managers should have their own capital invested in the fund, as a high ownership stake signals both confidence and accountability for fund results.

Ultimately, investors must determine what alternative investments are the best choice for their portfolio, particular in terms their goals and appetite for risk. But for those who seek to realize a predictable monthly income, while protecting their principal with a commodity that can be resold if need be, mortgage pool funds offer excellent potential.