Alternative Investments

An Alternative View

Tuesday, May 17, 2022

For years, you’ve dined on meat and potatoes; sturdy fare that’s given you the strength and endurance you’ve needed. Now, however, while the prime cuts of meat still deliver, the potatoes are drying out – less quantity, quality and nourishment. To get the sustenance you need, you’ve had to look elsewhere – to vegetables, fish … heck, you’ve even contemplated fast food. The taste rewards seem endless, but the risks of the unknown are daunting.

If you haven’t guessed – and no one will judge you if you haven’t! – that’s a food-as-investments analogy. Meat as stocks, potatoes as bonds and alternatives as pretty much anything else. It illustrates the dilemma facing investors – how to feed your portfolio with the income and diversification you need when bonds are being beat up by rising interest rates and spending power is being curtailed by inflation.

The move away from the 60-40 stocks-bonds portfolio model is not breaking news; pension funds have been increasing their allocations to alternatives for years. In 2021, Canada Pension Plan had about 9% of its total assets in real estate alone and a whopping 25% in private equity.

Now, in 2022, there is an ongoing democratization of these strategies. Through liquid alternatives, for example, everybody now has access to a buffet of investment options.

What are alternative investments?

Typically, they are an asset that does not fall into one of the conventional categories, like stocks, bonds and cash, which offer the prospect of a different risk-return pattern over time. These include a range of investments, including private equity or venture capital, real estate, hedge funds, managed futures, commodities, art and antiques, and cryptocurrencies.

Diversification is a huge draw when contemplating alternatives, which tend not to move in lockstep with traditional markets. But not all alternative investments or strategies are created equal – each has a different correlation to global equities, for example. Whether it’s long-short strategies, event-driven merger arbitrage, real estate or Bitcoin funds, there are a number of avenues to access almost all global markets.

Let’s look at some of the options.

1. Liquid alternatives

Liquid alternatives are mutual funds or ETFs that attempt to mimic alternative investment strategies. They were given the regulatory green light in Canada in January 2019 and have grown in popularity by providing access to strategies previously exclusive to family offices and pension funds.

By removing prohibitive high fees and the lack of liquidity and transparency associated with many hedge funds, investors have embraced the chance to add to their plate of meat and potatoes. To stretch the food analogy, it’s the trendy vegan option.

Investors have access, therefore, to short/long, leverage and market neutral strategies via liquid alternatives that, crucially, tend to have low to negative correlations to equity and fixed-income markets.

2. REITs

Real estate is the most recognizable alternative. At its simplest, an investor can simply buy a property and rent it out for an income stream while (hopefully) enjoying value appreciation.

Another way is to invest in a real estate investment trust (REIT), a company that finances income-generating real estate by pooling the capital of numerous investors. REITs don’t offer the investor much in the way of capital appreciation, but they are modelled after mutual funds and are highly liquid, in contrast to directly owning real estate.

There are many different flavours of REITs, from apartment buildings, warehouses, residential blocks to retail centres and hotels. This requires market judgement. For example, during the pandemic, warehouses performed well but residential and office space lagged. Will this change as people return to work? A long-term strategy is advisable.

Another big consideration in 2022 is interest rates, with the Bank of Canada only just starting a series of expected hikes designed, in large part, to keep a lid on inflation. On one hand, instinct tells us this is bad news for mortgages, affecting the cost of borrowing and potential returns. However, on the other hand, those more bullish on the sector will tell you focuses on only one aspect.

The alternative perspective is that if rates are rising, this is generally because the economy is strong, job growth is good, and wage inflation is up; the same variables that drive free cash flow for real estate. This means occupancy goes up, vacancies are lower and rent increases, often faster than the pace of inflation.

So, REITs come with notable advantages in high-yield dividends, liquidity, and accessibility, but changes in property value might result in volatility. Like with any investment, check the layers of possible fees and admin costs. You’re also not the actual owner of the underlying property assets so, as an investor, you have no control compared to actually owning the bricks and mortar. Therefore, take time to know the people in charge of the REIT.

3. Gold (and other metals)

After real estate, gold is arguably the second most visible alternative. With rising consumer prices, the big story of this year, you may have seen the precious metal crop up in numerous headlines given its hard-earned reputation as a historical inflation hedge.

A long-term store of value, many people use it as a portfolio insurance policy and an allocation up to 10% is not uncommon. It has a low correlation with other asset classes, a trait that becomes more obvious in tough times.

For the ultimate store of value, investors can buy and store gold bullion like coins or bars (beware of storage costs) but if that’s not for you, and you’re seeking more of a pure hedge, you can invest in ETFs, mutual funds, or directly into mining companies.

Silver and platinum represent other investable precious metals. Both are industrials and, therefore, also have a value tied to an industry, be that via electrical conductors and batteries or, in platinum’s case, automotive catalysts.

Copper is noteworthy in 2022, given the impact on supply chains of Russia’s invasion of Ukraine. Both countries were players in the market, but the conflict has resulted in disruption, a jump in prices and a windfall for producers like Chile.

4. Private equity

For institutional and accredited investors – i.e., those with substantial capital – there is always the option of going away from the public markets. Private equity is the direct investment in private companies or in the buyout of a public company to take it private. Some private equity firms are now including Special Purpose Acquisition Companies (SPACs), also known as “blank cheque companies”, in their toolbox.

For high-net-worth investors, the advantages include the potential for high returns and the relative lack of volatility compared to the public market. In theory, a private company is allowed to grow and reach its potential free from the glare of quarterly reporting. On the flip side, holding periods tend to be lengthy before investors get a return on their capital, while liquidity is dependent on finding a buyer. In addition, prices are not set by the market but are instead decided on a case-by-case basis through negotiations.

5. Private debt

Not to be confused with its equity cousin, private debt entails companies selling fixed-income products, such as bonds, bills, or notes, to investors to obtain the capital they need to grow. The investors – retail or institutional – provide a company with debt financing and, unlike with private equity, must be paid back in the future, at an agreed date.

With interest rates at historical lows, this alternative asset class has gained traction in recent years given its potential for attractive yields compared to government and corporate bonds. Higher returns are possible because its illiquidity premium (it’s not traded daily and pricing is not transparent), while it offers valuable diversification and low correlation to public markets.

Private debt is viewed as more predictable and less risky than private equity, and it offers a wide variety of access into numerous industries and risk/return profiles.

6. Cryptocurrency, fine art … and wine

The fun stuff and, typically, the slice of a portfolio that an investor reserves for the more speculative areas. Think of it as your dessert – if it doesn’t work out, it still hasn’t ruined your meal.

That’s not to dismiss these asset classes as not serious. While Bitcoin remains hugely volatile, and questions abound as to whether it’s an accepted store of value, the price has increased nearly 50% over the past five years alone. If you believe in the principles, and potential, of a decentralized currency and the blockchain technology behind it, an allocation to crypto is a natural extension of your investment portfolio.

Investors must take into account, however, that this is a fledgling currency, and its final destination is unknown, despite what evangelists say. Regulators are swirling and central banks, understandably, are defensive. If buying crypto direct feels too risky, there are numerous ETFs and funds now available that offer accessible and diversified exposure to the leading cryptocurrencies and the technologies behind them.

Sitting at the head of the dinner table are the fine art and wine lovers. Arguably even more than crypto, this is often a case of marrying your hobby with your investments. There are an increasing number of firms that try to democratize this space by enabling people to make relatively small investments in pieces of art or a portfolio of vintage wine.

Final word

There is a common thread through all these alternative investments – diversification. The post-pandemic world remains uncertain – what will downtown offices look like, for example? – inflation is rising, and war and division dominates the news cycle. Emotionally and statistically, restricting your portfolio to variations on the stocks and bonds theme doesn’t make sense. Whether it’s income you need or protection from the next market correction, alternatives, with the right help from a trusted advisor, can add ballast to your portfolio. Maybe it’s time to spice up the menu.

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