Key Takeaways
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Alternative investments offer diversification benefits in the face of uncertainty.
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There are different types of alternative investments, each with their own strategies and perceived risks and rewards that cater to a wide array of investor profiles
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There are myths surrounding alternative investments and we offer some steps forward
We may be turning a corner on the pandemic, but our lives are far from “back to normal.” Amidst high inflation, interest rate hikes and volatile equity markets – especially in response to the situation in Ukraine – a sense of stability remains precarious.
Enter alternative investments. Though they’ve been around for a while, we’re witnessing a rise in alternative investment allocations to portfolios far and wide, a testament to their capacity for diversification and protection from volatility.
But what exactly are alternative investments and how effective are they in meeting those expectations? A recent BMO Private Wealth conversation explored the topic in depth with Ewa Townsend, Director and Alternatives Strategist and Matt Soegtrop, Associate Director, Responsible and Alternative Investments. Hosted by Naveed Mohammed, Vice President and Head of Investment Manager Research, the discussion delved into the case for alternative investments, explored the realities versus myths, and offered some valuable insight for those looking to strengthen their portfolio.
Alternative Investments Defined
Alternatives investment, or alternatives, include a variety of investments that don’t fit into the traditional asset classes of stock, bonds and cash. We often refer to private assets and hedge funds when discussing alternative investments, both of which can provide significant diversification benefits.
Private assets include private equity – consisting of capital invested primarily in ownership stakes of companies not listed on public exchanges. It also refers to private debt – debt held by or extended to privately held companies – and real assets, investments made in areas such as infrastructure and private real estate.
Hedge funds are the other type of alternatives. Hedge funds typically utilize traditional securities on public exchanges but can use unique tools such as short-selling, leverage and others to create differentiated return profiles.
Private Equity
Perceived Risks
As mentioned, private equity refers to capital investments made in companies which aren’t publicly traded. If you’re thinking of taking an “alternative” leap (or just a toe dip) into private equity, it’s important to understand the perceived risks. For one, there’s the liquidity factor, which measures the ease with which investors can get in or out of investments. Due to the unlisted nature of these private assets, private equity investments do not offer daily liquidity and some offerings can lock up capital for many years. Liquidity terms vary greatly with some offering monthly liquidity while others do not allow any opportunity to redeem prior to the expiration of the fund.
Other perceived risks associated with private equity are the company’s maturity profile and a lack of diversification and transparency, the latter referring to the dearth of standard documentation (terms, asset requirements, and lock-up periods).
Private Equity Strategies
The most common private equity investment strategies are leveraged buyouts and venture capital investments. With leveraged buyouts, a company is bought out by a private equity firm and the purchase is financed through debt. The firm assumes control while putting up a fraction of the purchase price. By leveraging the investment, it aims to maximize potential return.
Venture capital is a strategy used more frequently when making equity investments in a young company in a less mature industry (think Internet companies in the1990s). Private equity firms may see a potential in the industry that is being held back, whether by a lack of revenue, cash flow or debt financing. The firm then takes significant stakes in the company, with the hope of creating growth.
Private Credit
The term private credit refers to business loans made by lenders other than banks, with each fund having a unique investment process and approach. In these scenarios, borrowers are small and medium enterprises and mid-market businesses. There is a range of lending profiles, sectors, collateral and positioning when it comes to private credit. But what distinguishes private credit from other investment options are the direct and tailored nature of its offerings.
Real Assets
Real Estate
Real assets comprise a few categories, most particularly real estate and infrastructure. A direct real estate investment involves buying a residential or commercial property (or just a stake in one) like an apartment complex or shopping center. Investors in direct real estate make money through rental income, appreciation, and profits generated from associated business activities of the property.
There are also private funds within real estate which adopt a closed-end or evergreen approach. Closed-end real estate funds have a predetermined life that is set by the manager at the fund’s onset. They raise a set amount and are legally required to terminate at a set future date. Evergreens, on the other hand, are open-ended fund structures with no termination date. They allow investors liquidity rights to exit their investment and for the fund manager to raise more capital.
Real estate can encompass public investments too. Real Estate Investment Trusts (“REITs”), for example, are publicly traded shares representing real estate investments whose revenues are mainly generated through rental incomes on their real estate holdings. Real estate investment trusts own and/or manage income-producing commercial real estate, whether it's the properties themselves or the mortgages on those properties. You can invest in the companies individually, through an exchange-traded fund, or with a mutual fund.
Real Estate Strategies: Perceived Risk & Reward
With real estate investment strategies, there is a potential for greater risk, and greater return. At the higher end of the risk continuum, for example, an opportunistic strategy will see speculative development, usually with high debt, potential for higher than average returns, and high variability.
Value-add investment strategies are moderate- to high-risk, represent a high upside, and potential for enhanced returns with variability. At the lowest end of the risk-return spectrum, a core investment strategy will see high-quality locations, high-quality tenants, and potential for returns with bond-like characteristics.
Infrastructure
Infrastructure investments support physical and organizational structures upon which society relies. They’re deemed attractive as they allow for an income stream that is typically non-cyclical, stable and predictable.
There are two types of infrastructure investments. Unlisted assets or private infrastructure holdings aren’t listed on an exchange (think roads, power grids, airports, shopping centres). Then there are public companies which are involved directly or indirectly in developing and operating infrastructure.
Hedge Funds
Hedge fund strategies primarily use liquid assets that trade on public exchanges but employ alternative strategies for the potential to perform in both rising and falling markets. Each fund has a unique investment process and approach, and the types of strategies vary to a significant degree.
There are several hedge fund strategies in play today. Long/short is a popular approach which takes long positions in stocks that are expected to appreciate, and short positions in stocks that are expected to decline. A market-neutral strategy, meanwhile, pursues a profit regardless of whether there’s an upward or downward market environment. The fund has the potential to mitigate market risk in their pursuit of positive returns in all market environments.
Common Alternative Investments Myths
1. High fees are not justified
With the rise in passive investing, many investors are skeptical of high-fee products. What’s more, fee terms can be difficult to understand. Keep in mind that many believe alternatives can’t outperform traditional asset classes, making the fees even tougher to defend.
But here’s the thing: while alternatives do come with higher fees, on a net basis the best funds have generally shown an ability to meet their target return.
2. Liquidity terms are not flexible
It’s believed that all alternatives come with lengthy lock-up periods and offer little or no liquidity, causing investors to incur significant penalties if investments are redeemed early. The reality is that there’s a growing number of liquid alternatives which have democratized the space. “Alternative investments are becoming increasingly democratized and now cater to all investors,” says Matt Soegtrop, Associate Director, Responsible and Alternative Investments, BMO Private Wealth.
And let’s not forget that illiquidity has its benefits. To be sure, liquidity is valuable when you have specific needs for your capital (e.g., home purchase or renovations), or a short-term investment horizon. But less liquidity is beneficial if you want to access investments that can’t be easily sold (private equity, real estate, etc.), or if you don’t anticipate short-term needs for your capital. “It should be noted that less liquidity, is not always a bad thing. Less liquidity can really open the opportunity set in terms of the types of assets you can access. Giving up liquidity allows investors to access unlisted assets that are far less correlated to the broader, traditional indices,” Soegtrop shares. Simply stated: when it comes to investment strategies, a balance of liquid and illiquid investments gives investors the best of both worlds, he adds. “And they offer non-traditional strategies in an accessible, daily liquid format."
3. Alternatives are only available to high-net-worth individuals
It’s generally believed that alternatives are accessible only to the affluent who can meet specific criteria and afford to lock up their capital for a significant period. While these investments were traditionally geared to (ultra) high-net-worth investors, the landscape has started to shift; one likely to continue in the coming years.
What’s more, there are new players in the space. The launch of new alternative products, for example, with lower minimums and new structures will make it easier for the moreinvestors to take part in the alternative landscape.
Next Steps
Committed to providing clients with the right mix of products to help them reach their unique investment goals, BMO Private Wealth is proud to be offering a range of alternative investments. “We believe it’s more important than ever to pay attention to alternatives as volatility spikes and rates begin to rise,” says Soegtrop. Considering the state of our world today, beset by tumult and uncertainty, it might be appropriate to explore new options than may provide broader diversification and risk reduction in one’s portfolio. “Alternative investments can provide significant diversification benefits to a portfolio as empirical evidence has shown that can outperform traditional assets during periods of market turmoil.”
Information contained in this publication is based on sources such as issuer reports, statistical services and industry communications, which we believe are reliable but are not represented as accurate or complete. Opinions expressed in this publication are current opinions only and are subject to change. BMO Private Wealth accepts no liability whatsoever for any loss arising from any use of this commentary or its contents. The information, opinions, estimates, projections and other materials contained herein are not to be construed as an offer to sell, a solicitation for or an offer to buy, any products or services referenced herein (including, without limitation, any commodities, securities or other financial instruments), nor shall such information, opinions, estimates, projections and other materials be considered as investment advice, tax advice, a recommendation to enter into any transaction or an assurance or guarantee as to the expected results of any transaction.
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