To enhance downside protection, it’s time to think beyond stocks and bonds
Alternative investments are a little like Michelin-starred restaurants – they offer something that’s hard to find anywhere else. And like these locales, they can feel out of reach to all but the most ultra-high-net-worth individuals. Fortunately, these investments, often called “alts,” are becoming more accessible to a broader range of investors who can benefit from adding these uncorrelated assets to enhance portfolio diversification.
The term alternative investments describes investments that fall outside the realm of conventional securities, like stocks and bonds. Typically, investors look to alts because they are not sensitive to economic cycles and provide downside protection. Alts can include private equity or investments in companies not listed on public exchanges, private debt and real assets, including private real estate and infrastructure. Hedge fund strategies fall into this bucket as well.
The benefits of uncorrelated assets
While there’s no denying some of these assets can be riskier and carry higher fees, Ewa Townsend, Director and Alternatives Strategist for BMO Private Wealth, says the potential for a higher and uncorrelated returns can outweigh any negative effects these fees have on the net return of a portfolio. Historical data shows that over a 10-year period ending 2022, a portfolio that included alts, such as Waratah One X, a net long/short fund that focusses on North American equities, and Polar Multi Strategy, which incorporate a range of strategies from event driven and arbitrage to structured credit and long-short investments, outperformed a portfolio that didn’t include them and experienced smaller losses over that same period.
While investors may worry about the lack of liquidity of alts, Townsend alleviates those concerns, especially in the context of a diverse portfolio. “If the portfolio is constructed in such a way where you can source liquidity from other assets, then what you’re essentially doing is providing the alternative fund manager with the ability to take advantage of higher returning investments that can be found in other assets because they don’t need to meet daily liquidity demands.”
Still, accessing this part of the market has been a challenge. Previously, non-traditional investment strategies were relegated to investors that were able to attain ‘accredited’ status. The fact that many alternatives can have significant barriers to entry and have liquidity profiles that are not suitable for all investors, was another barrier, says Townsend. Liquid alternatives attempt to democratizing this space, by providing access to the same return profiles that investor’s desire in traditional alternatives but in a mutual fund format.
Follow the money
Here’s another reason to pay attention to alternative investments: it’s where the smart money is going. Globally, alternatives are expected to surpass US$17 trillion by 2025. Institutional investors, such as pension funds, foundations and endowments, account for a significant share of that figure, with allocations that range between 20 to 40 per cent of their overall portfolios.
“The expectation from these managers is that alternatives are not only going to remain a core position in the portfolio but that the allocation to the asset class is going to increase,” she says. “The fact that institutional investors have such a large allocation already carved out points to reasons why investors might consider making an investment.”
How to make alternative investments a part of your portfolio
For those interested in dipping a toe into alternative waters, Townsend recommends evaluating your portfolio from a liquidity standpoint before making any decisions. Alts exist on a liquidity spectrum: At one end are hedge funds (e.g., funds that focus on more complex strategies like long-short investments or distressed credit), with monthly redemptions (or better), no lockup periods and more modest returns. At the other are private strategies offering limited to no liquidity, with lockup periods ranging from seven to ten years and more enticing returns.
“To start, investors could consider building an allocation of around 20 per cent to alternatives using the more liquid strategies,” Townsend says. “This will help deliver attractive returns, maintain portfolio flexibility and get you comfortable with the most liquid strategies available under the alternatives umbrella. The next phase would be to introduce private markets to the portfolio through more hybrid strategies and then, lastly, continue to increase their allocation to traditional private vehicles out of those hedge fund strategies.”
An end goal could be to reinvest the distributions from certain vehicles to arrive at a rolling portfolio where the weighting of alternatives might be around 20 to 30 per cent. Specific investments shouldn’t be based on the appeal of any particular alt but on the portfolio as a whole. “It depends on where an investor is in their wealth accumulation goals,” Townsend says. “There’s a product that’s suitable for every investor.”
Assessing the risk
As far as risk is concerned, any product BMO Private Wealth offers must first go through a due diligence process and be unanimously approved by a committee that is independent of investment professionals. Bank stakeholders, including representatives from research, legal, risk and compliance, all have a say, and the due diligence process continues for as long as the product is offered.
“From our lens, if a manager is reluctant to share information, then the game ends there,” Townsend says. “If fund portfolio managers are not available to address ad hoc questions and speak to their strategy, performance and different decision making, then it’s not the type of manager we like to deal with.”
BMO Private Wealth recently performed analysis on its list of recommended alternative investments and found they outperformed the FTSE index over the past 10 years, while experiencing substantially less volatility. “Not all alternatives and their managers are made equal, but you have the same thing in traditional markets,” Townsend says. “It’s a matter of identifying what is suitable for your portfolio and ensuring that the manager and strategies align with your objectives.”
Ultimately, the only way people will become comfortable with alternative investments is by learning more about them. This involves reviewing your portfolio and talking to your investment professional to determine which strategies and products are right for you.
“When it comes down to it, it’s not rocket science,” Townsend says. “Don’t be afraid to ask questions because the only way one can benefit and be comfortable with this asset class is if you actually understand what these products are, what they mean and what they are meant to do in various market conditions.”
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