Reward and Risk in Alternative Investments
The point of investing is to make a profit. Some folks are happy to stay a percent or two ahead of inflation and simply not lose any of their hard-earned money. And others would prefer to multiply their holding every few years. How do you find success in making more money and not taking on more risk? One of the approaches that have worked is to pool assets and then invest in a broad range of more risky but better paying alternative investments. In regard to reward and risk in alternative investments, we would like to look back a few years to Michael Milken and junk bonds and then fast forward to today and a company that is selling alternative investments and wants sell them to masses.
Michael Milken and Junk Bonds
When he was only a 20-year-old student at the Wharton School of Business, Michael Milken read something written by a member of the Federal Reserve Board and over the years put the idea into action. Companies that were poor investment risks had to pay much higher rates of interest in order to sell their bonds. Investors demanded a higher return because of the increased risk that the company would default on its debt. But, if an investor purchases a wide range of these bonds, the rate of return was such that, even with defaults, the total investment made a better return than high grade bonds.
Business Insider wrote an article about Milken that included his conviction for securities fraud and time in prison followed by a life of philanthropy. They describe the invention of the modern junk bond as the best thing to come to the world of finance in recent memory.
To this day, high-yield bonds, as they are now more genteelly known, remain a brilliant innovation because they elegantly solve a simple yet ubiquitous problem: They give companies with less than stellar credit ratings access to capital. These bonds created and grew entire industries, such as wireless communications and cable television, just as they created and grew immense pools of wealth. Their invention combined with the packaging of credit card receivables, mortgage payments, and car loans into securitized products that loosened lending for individuals has done nothing less than bring about the democratization of finance.
In the case of high yield bonds, it turned out that by packaging them in large and diverse groups that the risk was simply part of the cost of doing business and these investments were more profitable than bonds issued by healthy blue chip companies. This idea has reemerged and brings us to a look at reward and risk in alternative investments today.
Is It Investor Populism or a Con Job?
Bloomberg just published an article entitled Populism Comes to Wall Street. The article is about a company named YieldStreet, their investment products and how they would prefer that the SEC relaxed its definition of a “qualified investor.”
One of YieldStreet’s founder, Milind Mehere is quoted as saying this.
“If we don’t change fundamentally how we save, invest, and actually make money as a society, there will be anarchy in 20 or 30 years,” he says.
The company says that they will democratize high finance and bring investment opportunities usually reserved for billionaires and hedge funds to the average investor. One of the keys would be to use a crowdfunding approach.
How do this company and its investment ideas compare to Milken’s development of the junk (high yield) bond industry that revolutionized finance? We know from hindsight that the junk bond idea works. What YieldStreet wants to do is in its early years.
Founded in 2015 by Mehere and two other Wall Street entrepreneurs, YieldStreet has allowed investors to put more than half a billion dollars into exotic debt securities. More than 80,000 people have signed up to receive its offering notices. Since inception, the investments have an expected internal rate of return of almost 13 percent and to date haven’t lost any principal. In the same period, the S&P 500 appreciated an annualized 9.3 percent. With many individual investors eager to juice their returns, some YieldStreet offerings sell out in seconds.
The thing that is holding this company back from expanding is the Security and Exchange Commission or more specifically its accredited investor rule. Investopedia defines accredited investor.
An accredited investor is a person or a business entity who is allowed to deal in securities that may not be registered with financial authorities. They are entitled to such privileged access if they satisfy one (or more) requirements regarding income, net worth, asset size, governance status or professional experience.
The point of the law is to protect naïve investors from losing their money. A rich investor may be naïve but has the protection of abundant wealth. And, a professional investor will have knowledge and experience needed to sort out and avoid dangerous investments.
To the extent that this sort of investment parallels junk bond funds, then excluding regular investors seems undemocratic and exclusive. But to the extent that investors need to have more information and expertise to invest in such a vehicle, the accredited investor rule is protective.
What Kinds of Investments Does YieldStreet Offer?
This gets to the important part of the discussion of reward and risk in alternative investments. Can you package them in such a way that the sheer earning power of a bunch of them offset an occasional loss?
Mehere says YieldStreet has its legal team looking at a fund structure in which nonaccredited investors may participate.
This all makes some people nervous, because what YieldStreet sells is unusual. Many of its offerings involve litigation finance, in which investors front money to law firms or plaintiffs hoping for a big settlement. More recently the company has moved into marine finance, allowing investors to participate in loans for cargo vessels that transport dry-bulk goods such as coal or grain. Or they could jump into a deal in which vessels are acquired and sold for scrap. Each offering is backed by collateral, but sometimes that’s a litigant’s contractual obligation to pay investors back-if there is a settlement-or the scrap value of a ship.
A bit of investigation by Bloomberg reveals a concern. In at least one instance, the guarantee of a borrower paying on the debt is said to be backed by their substantial wealth. But, there is no proof of any wealth!
Another issue seems to be that the company’s owners are using this vehicle do business with separately owned businesses that they (the YieldStreet owners) own or control. There is an issue of how they track and control any conflict of interest.
Not everyone is excited about this opportunity.
“The percentage of accredited investors for whom they are appropriate is quite small,” says Barbara Roper, director of investor protection at the Consumer Federation of America. “They like to make it sound like it’s populist,” she adds, “but this doesn’t belong anywhere in the portfolio of the typical retail investor.”
It is our opinion that this may be a way for the average investor to make more money on his investment. The proof will be in how it does over the years and in how well the company avoids using itself as a cash cow for its individual owners and their business interests.