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Is Distressed Investing for “the Little Guy”?

Distressed InvestmentsGiven the focus of this site on distressed debt and equities, I’d like to highlight some points for those considering allocating some of their portfolio to distressed securities. The question I’ll address today is: should self-managed individual investors consider making their own picks in distressed securities? And if so, what is the best way to approach the space?

Modern studies tend to attribute at least 40% of a portfolio’s overall success to its diversification in the different asset classes.  (See, for example, this article.) So, over the long run, and over different market cycles, a mix of stocks, bonds, cash and alternative investments generally yields better results, with better risk-adjusted returns, than those portfolios focused on any one component alone.

This perspective definitely evokes the sensibilities of a Graham or Dodd type of conservative investor, who recommend allocating between 25% to 75% of a portfolio to non-equity securities. Especially given that most individual investors don’t have the time or inclination to develop their stock picking skills to a level approaching a Graham or a Dodd, the benefit of adopting such a diversified portfolio becomes all the more obvious.  This approach serves as a protective measure to hedge against times when stocks are cratering, a la a financial crisis, as well as a defensive mechanism when stocks are trading at relatively high levels. (And it should be noted that, according to some metrics such as the stock market capitalization to GDP ratio, the levels are actually very high today). (See here.)

Ultimately, no one can say what a particular investment or portfolio is going to do in the future. Structuring a balanced, diversified portfolio focused on low costs, and having the discipline to stick to a plan of execution (not deviating from the plan) would probably be the ideal strategy for most people. (For more on this, check out Joel Greenblatt’s excellent, and perhaps somewhat audaciously titled You Too Can be a Stock Market Genius, particularly chapter 8.)

Advisors often recommend allocating some 10-20% of a portfolio’s total assets to alternatives (for example, here), and distressed investments are probably one of the more accessible and attractive options. In terms of returns, distressed and high yield indexes have tended to outperform the market.

Take a look at these comparisons of distressed investment indexes to the general market:

(click on any to enlarge)

Distressed debt index returns (p 11)

Distressed debt & default index w S+P (p 14)

Comparison of returns (p 13)

(from the May, 2014 Global Association of Risk Professionals Chapter Meeting)

As exemplified in this data, returns have historically been very attractive, and there is an overall fairly low correlation between stocks and distressed investments, making it a good choice to fill up some of the “alternative investment” space in one’s portfolio.

So, once becoming convinced to move into the space, how does one go about doing so? We’ll consider the 4 main options, which I’ll expand upon in upcoming follow-ups:

  1. Investing directly in the equity or debt of distressed companies through the markets. However, this may be far too difficult to do correctly and consistently for the individual investor. Aside from the difficulty of being able to pick specific securities, the individual investor would also have the risk of putting a far larger percentage of his or her total portfolio into specific positions than a larger fund would.
  2. Buying in to a publically traded fund that focuses on specific distressed securities (examples include Fortress Investment Group, and Colony Capital)
  3. Buying in to a closed end distressed focused mutual fund (like some of Oaktree Capital’s mutual funds)
  4. Investing in a hedge fund or private equity firm which focuses on making controlling investments in distressed companies (which may be impossible for you if you’ve got less than a $1 million net worth, or $200,000 income/$300,000 for a couple).

I will delve deeper with an analysis and approach to individual distressed investments in an upcoming article here. Distressed investments could become one of the more attractive pieces you could have in your portfolio, and they are undoubtedly an effective way to help manage risk as part of an all around strategy..

Further reading:

An interesting discussion about some of the myths regarding individuals investing in the distressed space:

http://www.blackrock.com/investing/literature/market-commentary/10-myths-surrounding-alternative-investments-commentary.pdf

A good discussion for thinking about risk when it comes to constructing a portfolio:

http://www.cambridgeassociates.com/our-insights/research/from-asset-allocation-to-risk-allocation-the-risk-allocation-framework/

About Jon Peterson

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