Diversification is a well understood strategy that can be utilized to enhance returns, minimize risk or both. But what do you do when stocks and bonds – asset classes most portfolios use to create portfolio diversification – both start moving in the wrong direction?
After the bout of market volatility in 2022, stocks and bonds both lost value at the same time, prompting investors to wonder what other options they had. Some of this dialogue quieted off after the following two exceptional years from the public markets in 2023 and 2024; however, the reintroduction of volatility this year has caused investors to wonder if their portfolio is adequately protected from potential market shocks. For many, they may be contemplating including a new, uncorrelated asset class to their portfolio, such as alternative investments (“alternatives”). These investments can include hedge funds and private market strategies. Although private markets is a rather broad class of investments, itis most commonly used to refer to investment strategies like private equity, real estate, infrastructure and credit.
According to Arthur Diochon, Head of Private Markets, North America, BMO Private Wealth, the following are some of the reasons why you might consider alternative investments for your portfolio.
Lower minimums
Historically, alternative assets have been seen as the domain of institutional and ultra-high-net-worth investors who could afford the large, minimum dollar requirements and perform the due diligence necessary to invest in alternatives. But that’s changing.
In recent years, illiquid alternatives – as they’re often called – like infrastructure, physical real estate, private equity and private credit have become more accessible. In 2019, broader access to alternatives opened up when the Canadian Securities Administrators made regulatory changes that facilitated the ability of retail investors to more easily buy liquid alternatives – a broad range of investments beyond stocks and bonds – including hedge fund-style strategies such as market neutral, long-short funds or managed futures. These investment options are not only now easier to access and integrate into a broader portfolio, but they also come with lower minimums that allow investment by a broader group of investors, as well as (generally) daily liquidity, making it easier to buy and sell liquid alternatives.
Diversification benefits
Providing a buffer against volatility is part of the allure of alternatives because they tend to have low – or even inverse – correlations to the broader market. That’s important in today’s markets. The origin of the typical 60% equity, 40% fixed income balanced portfolio was born out of the belief that these assets moved opposite to each other. And for a long time, that was true. However, recent experience tells us these assets can move in the same direction when growing inflation risks put pressure on bonds and equity markets are under duress. The diversification benefits of alternatives have become more apparent in recent years, which has encouraged more investors to explore the asset class.
Depending on your objective and investor profile, your advisor might suggest reallocating a portion of your equity and bond holdings toward alternatives. The amount recommended will depend on your personal situation; however, a typical allocation may be up to a long-term target of 20% of a portfolio.
If alternatives are being added as a fixed income replacement, you might take more of your current portfolio allocation from bonds. But if your goal is to use alternatives to enhance your returns, then you could take more from equities. It really depends on what you want to achieve.
One of the reasons why some alternatives are more resilient in periods of market volatility is because they invest in private assets that don’t get priced on a daily basis and; therefore, aren’t exposed to market mania, while having other unique characteristics like private infrastructure or private real estate that may have attributes that further hedge against risk such as contracts that are indexed to inflation.
At the other end of the spectrum are hedge funds, which generally invest in securities that are priced daily. A common type of hedge fund are market-neutral strategies, which match long positions with an equal number of short positions which can cancel out the market effects in the strategy. These can reduce volatility while having greater liquidity than private markets.
Raising awareness
Although alternative investments are a rapidly growing market worldwide, many Canadian investors continue to maintain a more traditional mix of stock-bond portfolios. However, these investments are gaining traction, and more and more advisors are educating their clients about alternatives and how they can incorporate these strategies into their portfolios.
“At BMO, we do extensive due diligence on alternatives to make sure you’re investing shoulder-to-shoulder with high-quality managers. To ensure we have the best team and coverage, we recently merged our Canadian and American research teams to create a joint North American platform and are expanding our coverage, and opening up new opportunities for clients, say Arthur Diochon. “The goal is to provide the best insights and have access to the top managers so we can meaningfully improve the outcomes for clients interested in these investments for their portfolios.”
According to Diochon, their research has consistently found that alternatives are a place where proper diligence and insights can help investors make prudent investment decisions in this space to achieve their goals.
A key to investing in alternatives is being mindful of your needs and ensuring your portfolio is set up in the most effective way possible to help you succeed. It’s important to approach alternatives in a strategic way, rather than incorporating them simply because it seems like an interesting time to do so.
Potential investors should spend the time to understand what they are buying. To help investors, Arthur Diochon advises that, “Your advisor, in conjunction with BMO’s North American team, can help you determine the best asset allocation for your needs and to understand the different alternative investment opportunities available in the market and help you select the one’s that’s best suited to your objectives and situation.”
