Low-Risk Passive Income That’s High Yield
Ever since Tim Ferris made the broader public aware of the “4-Hour Workweek,” people have been dreaming about how they might be able to get rich by working half as much as they do now. That makes about as much sense as it sounds. There are plenty of digital nomads out there who promise they’ll show you how to “make money working anywhere” just like they did. Then you find out that they made all their money selling people some ideas about “making money working anywhere” which didn’t work for them so then they pivoted into telling other people “how to make money anywhere.” The truth is, you need money to make money. In order to work less, you need something called “passive income.”
Low Risk vs. High Yield
As the name implies, passive income is money you make while sipping margaritas on the beach and doing absolutely nothing. It goes without saying that you want this income stream to be as dependable as possible. In other words, low risk. After all, you plan to live off it. One of the most common low-risk investments is a bog-standard savings account. Unfortunately, it won’t pay very much.
Let’s pretend you have $250,000 that you saved up and want to generate passive income with. If you put the money into a high-yield savings account at CIT Bank, the current rate is about 2.45%. This means you will get $510 a month in passive income. That’s not a whole lot. Also, interest rates will change, and you need both predictability and consistency. You could get better yield by purchasing a bond which pays a fixed amount at varying intervals. The higher the yield, the higher the risk. Pretending that an investment could actually be “high yield and low risk” is exactly how we ended up with the Lehman Brothers debacle.
We haven’t even brought up inflation yet. If your income stream doesn’t increase over time to offset inflation, you technically lose money every year. That’s why we invest the lion’s share of our money in a dividend growth investing strategy which focuses on companies that increase their dividends over time and have an established track record of doing so. We get a raise every year without having to suffer through a 360-degree performance review.
By now you’re beginning to realize that you need money to make money. You’re also realizing that the higher the yield, the greater the risk. In order to reduce your risk, you need a diversified portfolio of investments that provide a meaningful income stream. One company that offers a wide variety of passive income options that are newly available to retail investors is YieldStreet.
Founded in 2015, New Yawk startup YieldStreet has taken in $178.5 million in funding to develop a platform that allows retail investors to access “asset-based investments” that provide target returns of 8 to 20% with one to three-year durations. A few things immediately stand out here. These are exceptionally high interest rates compared to conservative bonds or the average dividend growth stock. The durations are also quite short. As with any investment opportunity, the first thing we want to understand here is how much risk we’re taking on. Let’s talk a bit about what “asset-based investing” is all about.
When you consider loaning someone money, it helps to have some collateral to secure the loan. If the bank gives you a car loan and you are unable to pay it back, they can then take the car and sell it. The proceeds from the sale of your car will then be used to pay back your loan. In order to reduce the risks associated with loaning someone money, you want to have collateral that can be liquidated to easily cover the loan in case they default.
What YieldStreet provides are opportunities for accredited retail investors to participate in loans that are backed by assets that act as collateral. (They’re working on a vehicle for non-accredited investors which will probably be a blended portfolio of asset-based investments.) In the past, asset-based investing was largely the domain of hedge funds and institutional investors. Today, retail investors have already used the YieldStreet platform to invest $649 million across over 120 different types of investments that consist of loans secured by various forms of collateral as seen below.
In order to minimize your risk as much as possible, you would want to maximize the number of investments you make. According to the YieldStreet FAQ page, minimums range from $10,000 to $15,000. Let’s take the middle of that range at $12,500.
Back of the napkin math says that our original example of $250,000 would allow us to make 20 different investments of $12,500 each. After four years of operation, YieldStreet claims an expected 12.41% Internal Rate of Return (IRR) after deduction of management fees and all other expenses charged to the fund. Using our fictional $250,000 investment, that would translate into passive income of $2,585 a month. That’s about 5X as much income as we would get sticking the money in a savings account and enough money to live on in a large number of cool countries. So, what about the risks?
A not-so-obvious risk is the platform itself which presents a systemic risk. (And to a lesser extent, so do any third parties they’ve engaged to manage the loans.) If YieldStreet blows up for whatever reason, that could pose a problem. It doesn’t matter how competent the YieldStreet management team is, anything can happen. You can probably think of a dozen examples where investors lost money investing it with smart people who were deemed “too big to fail.” Let’s ignore systemic risk and focus on what we can control.
Diversification = Lower Risk
What we can control is the amount of money we invest and the number of investments we make. YieldStreet does a tremendous job of detailing every single one of their 121 investments, but if you want lots of diversification, you don’t have time to go through all the paperwork. Just spread your money across as many assets as possible and let them do what they do best. There’s a commonly cited “rule” in the finance world that says you can obtain 95% of diversification benefits by holding 32 stocks. While that statement may be declared a myth by some, it’s still a good rule of thumb. This means you would need $400,000 to invest in 32 investments to be ideally diversified. The problem is, it’s not that easy.
As we talked about earlier, YieldStreet calculated their IRR based on a 4-year timeframe which ended in December 2018. Their platform lists 121 investment offerings today (53 of those have been fully repaid). That equates to about 2.5 new investments per month. At that rate, it would take about 13 months to invest in 32 different investments. You also need to consider that with the short duration of one to three years, you’ll find yourself having to manage the portfolio a lot more than normal. The need for a good pipeline of possible investments is why YieldStreet made a recent acquisition.
YieldStreet Buys Art
Just days ago, YieldStreet announced the acquisition of Athena Art Finance. We’ve talked before about art as an asset class, and the idea is that investors can provide loans with art assets as collateral. (Bear in mind that the type of person who has pieces of art lying around that they can take million-dollar loans out against is probably someone who is a low risk for default.) An article by Forbes earlier this year provided some basic numbers on Athena Art Finance:
Since launching in May of 2015, it has completed about 110 deals, valued at around $560 million invested on the platform from individual investors and counts 100,000 as customers. The average investor has money in four deals at any given time.
It makes a whole lot of sense why YieldStreet would purchase Athena Art Finance, but some think there could be trouble ahead. Back when Athena was founded in 2015, Pictet Private Equity and The Carlyle Group ponied up $280 million in funding to get the venture off the ground. YieldStreet acquired whatever that turned into for $170 million meaning the original investors would have received less than 61% of their original investment. Why? An article by artnet news does a good job of mulling this over.
The higher your net worth, the lower the risk you take. If you’re someone who takes 5% of their entire investment portfolio and buys up 32 investments from YieldStreet for $400,000, that means you have an implied net worth of around $8 million. It also means that the most you could lose if YieldStreet blew up tomorrow would be 5% of your assets. That’s the number you should start with. What percentage of your overall investment portfolio should you put on the platform?
The entry level net worth needed to be considered an accredited investor is $1,000,000. Someone with a portfolio that size would probably look for a much smaller set of investments that they understood and felt comfortable with. Five percent of $1,000,000 is $50,000. For that, you can get a portfolio of four loans that would produce an expected return of $518.75 in monthly income – or about the same as if you put $250,000 in a high-yield savings account. That’s about as close to low-risk, high-yield as you’re going to get being a retail investor.