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Alternative investments are becoming increasingly popular. Used for decades by pension funds, endowment funds and high net worth individuals, Canadian alternative investment funds are slowly finding their way into more “regular” sized portfolios.
Unlike traditional investments like publicly traded stocks and bonds, the two main benefits of many alternative investments are that they are less correlated to the stock market (making them a great way to diversify your investment portfolio) and they can potentially offer higher returns.
Generally speaking, alternative investments, such as hedge funds in Canada are usually open to accredited investors who meet certain requirements. This may mean that a person’s income has exceeded $200,000 for the past two years, or that their financial asset net worth exceeds $1 million. This requirement does not apply to our clients. As portfolio managers, we qualify as accredited investors, we perform due diligence on the various offerings available and we determine whether such investments are in the best interest of our clients.
There are several types of alternative investments to choose from, and if we choose any, it is important to find the best options for your portfolio. Our list below will give you an idea of the types of investments your portfolio may benefit from.
Many alternative investments, like real estate, infrastructure and private equity, are illiquid. This means you cannot exit and sell your investment as easily as you could with traditional investments. Alternative investments also often involve higher fees than publicly traded stocks and bonds (or stock and bond funds). This is a consideration we need to weigh against the benefits of such investments. Having said that, you can usually expect a higher return as a premium for this reduced liquidity. Additionally, such investments usually require a long enough investment time horizon / holding period. For example, possibly 5+ years in the case of private debt or 10+ years in the case of private equity.
These investment funds pool capital from several investors and are managed by experts who invest in a variety of assets including public equities. These investments are unique because they involve complex portfolio-construction and risk-management techniques. Hedge fund managers study markets and use different styles and strategies to manage funds. Unlike the other investment options on this list, hedge funds can be more easily liquidated meaning if you invest in them, you can get your money out more easily. We have access to most Canadian hedge funds for our clients, as long as they are on the approved lists of the third party custodians where client accounts are held. A lot of these Canadian hedge funds are even RRSP eligible.
Private equity investing focuses on private capital markets for shares of companies that are not listed on public exchanges. For portfolios that we oversee, this type of investment is usually done through a fund rather than directly through buying shares in private companies. The reason for that is risk management: private equity only typically represents a portion of an overall portfolio and any one company only then represents a portion of a private equity fund. Having proper diversification in private companies is even more important than it is for public companies as they tend to be earlier stage and therefore riskier.
Private equity funds can invest in many stages / phases of growth of a business. Segments of the market that we currently like and invest in are what are called mid-market buyouts, growth equity and venture capital. We have access to some Canadian private equity funds, one of which is even RRSP eligible. As most new clients will likely not have any allocation to private equity, even for money that they do not expect to need to use for a very long time, this is an area that we may look at adding to their portfolios. In comparison, our Canada Pension Plan (CPP) has about 24% of its net assets in private equity and the renowned Yale endowment fund has about 33% of its assets in private equity!
An interesting and usually underutilized asset class, private credit consists primarily of loans to private rather than public corporations that for one reason or another cannot or choose not to obtain bank financing. These loans pay investors well and they tend to be in the following areas:
Private debt as an asset class is one of the areas that we are likely to add to a new client’s portfolio. The CPP and other big institutional investors have a double digit exposure to private debt and most individuals and families tend to have very little if none. As yields in private debt are more attractive than in public high yield bonds and the volatility is lower private debt tends to be one of our favorite asset classes currently.
In rare cases we may hold shares of your private company directly in your account. This can be for a variety of reasons that are specific to you, such as holding shares of a company you have direct control over in your RRSP if eligible, or other reasons specific to you.
Investing in property can be a wonderful way for investors to diversify their portfolio. Again, for our clients, for diversification benefits we would normally invest through a fund, such as real estate investment trust (REIT), rather than directly in properties. There are publicly traded REITs as well as private REITs. Public REITs are liquid. Private REITs are not but have much lower correlation to the stock market and can be more attractive. As many of our clients already have a considerable portion of their net worth exposed to real estate due to the the high valuations of Canadian residential real estate we tend not to add to it in their investment portfolios by investing in REITs.
Investing in commodities is another alternative that big pension funds and endowment funds have utilized for decades, primarily as a hedge against inflation. While commodities have been out of favour in the last ten years or so, they may still have a place in clients’ portfolios.
Bailing out systemically important companies that were too big to fail during the financial crisis, extremely accommodative monetary policy by central banks for over a decade in the form of low interest rates again as a response to the global financial crisis of 2008 as well as fiscal stimulus in the form of massive budget deficits by the US government and others has created a massive amount of debt owed by western nations to bond investors which can realistically only be paid back with synchronized devalued currencies. Add to this the global response to COVID-19 with additional borrowing and quantitative easing, the case becomes even stronger. Commodities and precious metals should fare well under such an environment over the next three to four decades.
Similar to real estate, real assets are assets that increase in value over time and have little direct correlation to the stock market. These assets might include toll roads and bridges, agricultural land, collectibles such as coins or art, wine, exotic cars, etc. The downside of these assets is that they may be really illiquid, meaning you cannot get your money out as easily or often. While there may be some very good benefits to owning such assets, unfortunately at the moment we do not have access to a single such Canadian domiciled fund for our clients to invest in. We are on the lookout for that.
In conclusion, diversifying your investment portfolio is one of the best ways to protect yourself and your family against the risks associated with investing in the stock market. While alternative investments are one of the best ways to diversify your portfolio, choosing where to invest your capital involves considering a variety of factors such as how much you value liquidity; whether you are willing to pay extra fees to a fund manager or whether you would rather invest on your own; your current net worth and income; and whether you want to collaborate with fellow investors or invest alone.
Working with a fiduciary investment advisor can help you clarify your goals and choose which investments align with your values and needs. Constantine Lycos leads the team in alternative investing.
Constantine Lycos leads the team in alternative investing.
