“Constructing a portfolio today without alternatives is as unthinkable as buying a car without airbags.” – Brad Simpson
When buying a car, we probably don’t even think to ask the question, “Does it have airbags?”. Back in the 1970s, when airbags were first made available to the public, consumers had to pay extra to receive the safety feature. Today, however, airbags are considered to be a standard detail, and no one even has to wonder if a vehicle has them – instead, the question has now become “How many airbags does the car come with?”.
Several years ago, I read a white paper by Brad Simpson, Chief Wealth Strategist at TD Asset Management. The quote above is one of many I took away from his report, which posed the question, “Should alternatives be considered the new standard in portfolio construction?”. Much like the evolution of the airbag, we have seen advancements in all aspects of life, from technology to manufacturing – so why is it so hard to think that it might be time for an evolution in the way we construct our investment portfolios?
I started my career in the financial industry in January 1990, working for a mutual fund company in Montreal. I grew up on asset allocation, tactical asset allocation modelling, and of course, the 60/40 portfolio that consisted of the traditional mix of 60% equities and 40% bonds. My advisor at the time informed me that the only strategy I needed was the 60/40 allocation and not to worry about anything else – and that held true for a long time. Interest rates were in the high single digits, and long-term performance for equity markets remained consistent; even high, single digit returns on traditional fixed income investments provided hope to retirees.
However, that hopeful perspective eventually began to wane due to the rise of a twofold issue: public markets became increasingly volatile and interest rates steadily decreased. Since then, there have been numerous articles published on the belief that the 60/40 mix is dead. A great example of this in practice can be witnessed by our very own Canadian Pension Plan (CPP) – in 2005, coincidentally the same year Invico Capital Corporation was founded, the CPP had allocated 4.3% to alternative strategies. Fast forward to today, and it has now increased its allocation to well over 50% alternative or tangible assets. The CPP must maintain a return to meet its obligations and sustainability of the fund to meet the growing demand as an increasing number of Canadians reach the age of retirement. Currently, 10-year government bonds are paying around 3.34% (as of June 2023), which means a portfolio with 40% exposure to such a low return makes it much more challenging for portfolio managers to generate a return similar to that of the CPP.
This, in turn, means that many of today’s investors are going to face a tough market upon retirement. Even those retiring today find themselves experiencing headwinds due to the increased volatility mentioned above, historically low interest rates, and stock markets that only a few companies are driving (I’ve heard a BNN Bloomberg analyst call the S&P 500 the “S&P 5”). So, what does this mean for investors? How can we find solutions to help them meet their goals, especially in retirement?
This is where alternative strategies come in. You might be asking yourself, “Aren’t alternatives risky?”. I have worked in the alternative space for almost a decade now, and to be honest, when I first heard the term, I wondered the same thing. What I came to realize, though, is that risk is very personal and differs between each individual – what I find risky may not be considered as such by the next person. As a society, we also tend to generalize risk based on age – if you are 75 years old, for example, you are less likely to be encouraged to make a “risky” investment.
Additionally, we can’t overlook that most private investments are deemed “high risk” due to their relative illiquidity, meaning you cannot sell a private investment in a way similar to a public stock or bond. However, if this trait alone were to define “risk,” one could argue that you could not lose money in the public markets because you could just sell your stock; except…do you know of anyone who has lost money in the stock market? I know I sure do. Only the investor can decide how much of their portfolio needs to be liquid. The only other consideration is which trade off an investor is willing to make in exchange for liquidity and liquidity premium. If an investor is unable to access their money on a daily basis, similar to public stocks, then they will likely expect a premium in return. Since alternatives don’t mark to market their assets, they don’t typically get caught up in the psychology of the investor.
Additionally, investors can leverage alternatives to help avoid some of the volatility seen in the public markets while also potentially providing more consistent and higher returns than traditional fixed income. In fact, many of the alternatives I have worked with over the past seven years have outperformed the TSX substantially over the long-term. When you frame the narrative around alternatives in this way, I suspect investors will become more confident and perhaps want to invest more as they learn about the market’s long-term returns.
But don’t just take my word for it. Several white papers have been written about adding non-correlated assets (alternatives) to a client’s portfolio to help reduce volatility and protect investor’s wealth; public pensions, like the CPP and Ontario Teachers’ Pension Plan, shifted their strategy, as the public markets were not able to provide adequate returns and have since increased their asset allocation to include alternatives like real estate, infrastructure, private equity, private debt, and commodities; a report by Blackstone found that adding alternatives to a portfolio can help lower overall risk while increasing returns. And this consensus isn’t just lip service – the data and numbers support this notion as well.
The above graph compares an alternative portfolio (as indicated by the green line) to various public markets and a few income and balanced ETF’s. There are three key insights you can derive from this information:
- Between 2013 and 2022, there was minimal volatility in the alternative portfolio.
- Although the alternative portfolio underperforms in bull markets compared to other investments, it is still positive.
- If you need an answer to the question, “Why alternatives?” look no further than 2015, 2018, and 2022 – when markets were down, alternatives outperformed.
This last insight ties back to the airbag analogy made earlier – just like an airbag, alternatives can help protect investors and their wealth during periods of volatility and are something we as investors and advisors should strongly consider.
Lastly, I will leave you with one final thought. I just finished reading a book called “Back to Beer and Hockey: The Story of Eric Molson,” by Helen Antoniou. The novel recapped Molson’s 235-year history, but what I took to heart was a quote from Eric Molson regarding the corporation’s decision to raise capital by way of a dual class share option where Class A shares were non-voting and Class B shares were voting and held primarily by the Molson family: “When properly administered, the dual class mechanism allows for a longer-range planning horizon. This is especially the case when the voting shares are held by owners with strong values and ethics, who thoroughly understand the business, and who are committed to the long-term growth and survival of the company (as opposed to transient share flippers who just want a quick return).”. Molson’s perspective on the dual class mechanism serves as an excellent reflection of the current private and public landscape.
After more than thirty years in the industry and thousands of conversations with brokers, there is one thing that has remained unchanged in all that time – investors want to lower their risk without sacrificing returns. Alternative investments are a great solution to diversify a traditional portfolio and reduce exposure to common risk factors over the long-term. They also provide greater flexibility, enhanced returns, and an answer to the question, “How can we find solutions to help investors meet their goals, especially in retirement?”. Alternatives are helping redefine the efficient frontier and serve as the new standard in portfolio construction.