‘Ottawa’ Solid Returns Without Risk: Why Alternative Investments are the New Key to Portfolio Growth
Once upon a time a Government of Canada 10-year bond paid eight per cent a year. In fact, as recently as 1995 these interest rates were available.
Back then, investment gurus recommended that your bond weighting be in line with your age. Basically, if you were 75 years old, you should have an investment portfolio of 75 per cent in bonds. But, using that logic today, you are looking at significantly lower returns than in the past. A lot has changed in the last 21 years, and so must your portfolio.
The reason people recommended such a high bond weighting was in large part related to the volatility of investing. There was a sense that the older you were and the more that you were potentially relying on your investment portfolio for income, the less risky the investments should be.
Our desire for for lower volatility and high income hasn’t changed, but it’s not longer coming from traditional bonds. But, if you are using stocks to get high income, you may find they come with a lot of volatility. Crescent Point Energy is a classic example of what we see in portfolios for those seeking income: Three years ago it was paying $2.76 per share in dividends; the stock was trading at about $39 and was yielding over seven per cent. Today the dividend is 36 cents per share and the stock is trading around $19.
So, if bonds won’t provide high enough income, and high income stocks won’t provide enough safety, do you have any options?
One of the areas that we have looked to for insight has been leading pension plans and endowment funds. These plans have been reducing their bonds and, to a lesser extent, their publicly traded stock portfolios. Under the catch-all phrase of alternative investments, many pensions and endowments have instead been investing between 25 per cent and as much as 75 per cent (Yale University Endowment Fund) in alternative investments.
Alternative investments are essentially any asset that is not a public stock, bond or cash security. They are included in portfolios because they can either provide diversification benefits, income, enhanced returns, greater stability or, in certain cases, all of the above. They are often more sophisticated in nature, can include more complex financial instruments or invest directly in private markets. While the types of alternative investments are quite broad, ranging from real estate and venture capital to commodities and art, I will focus here mostly on those that provide higher and more stable income.
All of the income-focused strategies listed below have generated annual income of five to 10 per cent depending on risk level with very low volatility. The growth oriented strategies have typically outperformed the equity market, but with similar volatility levels.
Private-debt funds provide short- to medium-term lending to companies at rates in the 10 to 15 per cent range. At those rates, why wouldn’t these companies go to their local bank for lower rate loans? Since the financial crisis of 2008, banks have changed their approach to lending to small and medium businesses. Overall, they do much less lending in this area because the banks now have to set aside much higher amounts of “regulatory capital” on these loans — making them less profitable for the bank. In addition, banks can sometimes move more slowly when approving commercial loans than before, due to all of the additional regulations. If a business can make 25 per cent on its money, and it needs to pay 13 per cent to achieve that growth, it can make perfect sense to borrow funds more quickly at those rates.
Factoring funds These managers provide immediate cash to companies experiencing rapid growth. A typical example is a company that provides a product to a large retail chain. The retail chain loves the product and purchases more, but only pays their invoices in 90 or 120 days. The company providing the product goes to the factoring company and offers to “sell the invoice for 95 cents on the dollar.” The company gets immediate cash, while the investment manager receives 100 cents on the dollar in three or four months from the department store; if they can do that three times a year, that is a 15 per cent return on their cash. This is a niche market in Canada, providing high rates of income with low volatility.
Mortgage Investment Corporations (MICs) These investment funds provide financing to builders, developers and property owners so that they can refurbish or purchase income-generating properties. These are private deals, so they can charge much higher rates than the banks. Due to the high property prices in Canada, we have focused on MICs with expertise of lending in the U.S. or that only provide first mortgages in Canada. Many of these investments are averaging steady six to 12 per cent returns, depending on the risk level.
Private real estate Real estate is one of the largest alternative asset classes, and it can range from ownership of properties, where investors earn a yield from rental income, to property development. Funds that own properties tend to provide similar distribution rates as REITs, but with much lower volatility. Funds focused on development tend to offer much higher potential returns, but they will fluctuate much more and a greater portion of the return will be capital gains.
Infrastructure is a direct investment in an essential facility, such as ports, airports and pipelines. Unlike investing in public infrastructure, such as a TransCanada pipeline, for example, private infrastructure values do not rise and fall with market sentiment, so returns tend to be very stable and pay out a high rate of income. The utility contracts tend to be long-term, e.g. 20-30 years often with the government being the key customer.
Hedge funds are essentially any investment fund that can employ complex financial instruments, such as derivatives, shorting or leverage and where a large portion of the return is derived from active investment management. Hedge fund managers typically focus on one area of the market, like stocks, or focus on niche areas, such as arbitrage. For low volatility, we have tended to focus on Market Neutral funds, which attempt to generate modest, positive returns in all market conditions by focusing on their best investment ideas and using hedging strategies, such as shorting or options, to reduce downside risk.
Other ideas that have become large investment areas in the U.S. include life settlements, which is essentially buying up a large pool of life insurance policies from people who have paid into them for years but now want to sell them. Another area is investing in legal settlements from contingency cases — essentially providing lawyers with the money to fund a number of cases where the payout on any one can be large, but some will not pay out at all. It is basically investing in the equity of litigation lawyers, who get paid very well.
Alternative investments are not for everyone as, unlike stock or bond investments, you cannot sell them on a daily basis — there can be a wait of anywhere from 30 days to one year to sell your investment. You also have less transparency concerning what investments you own. But, they can provide you with the benefits of high, stable income, lower portfolio volatility, and enhanced returns, making them both helpful and necessary in this low yield environment.
Historically, these types of investments have been for Institutions and very wealthy individuals. Today many of these investments remain aimed at the higher net worth, but for those with household investment assets of $500,000-plus, alternative investments are now increasingly available.
It’s 2016. The world has changed. It is time for your portfolio to change as well.
Ted Rechtshaffen is CEO of TriDelta Financial. He is hosting a Wealth Seminar Series in the Toronto area. If you are interested in attending please visit tridelta.ca/pcss