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Understanding Alternative Investments




Hello everyone and welcome to the Retiring Canada Podcast. In today’s episode, we're going to discuss alternative investments.


Specifically, we are going to cover:


- The two main types of alternative investments

- The three most common types of private investments

- How these fit into a retirement portfolio

- The risks involved

- Who's a good candidate to utilize private investments

- And lastly, a few action items for you to consider.


At their core, there are two main types of alternative investments. The first are private assets such as private equity, private credit, and private real estate. These are more complex and less frequently traded than public stocks and bonds, giving investors access to additional sources of diversification and return.


Hedge funds, the second type of alternative investment, operate mainly in public markets but use less traditional tools such as short-selling and leverage. There are other alternatives like crypto, collectibles, and structured products, but I won't be covering those today.


Today, I will be discussing private assets, which include private equity, private credit, and private real estate.


Over the last few years, you may have started hearing more about these kinds of investments and the potential value they can add to your retirement accounts. Although this kind of investing may sound new, pension funds like the Canadian Pension Plan, large institutions, and endowment funds like Yale and Harvard have been using these types of assets for decades.


So spoiler alert, if you have been contributing to the Canadian Pension Plan, then you have already been investing in alternative investments without even knowing it.


Why are these institutions and pension funds using alternative investments? There are four core reasons:


1. Diversification – Different asset classes with varying investment and risk profiles result in lower risk when combined in a portfolio.


2. Low Correlation – With the growth of ETFs, we’ve seen a big uptick in fixed income and equity correlation. Alternatives have low to zero correlation with equity markets and traditional fixed income options, creating a more efficient portfolio.


3. Reduced Drawdowns – Low or uncorrelated assets perform differently at different times. Alternatives perform more consistently with lower volatility, protecting portfolios from large drawdowns or losses.


4. More Attractive Risk-Adjusted Returns – With lower volatility than fixed income and equity, but high-income streams, alternatives may provide better risk-adjusted returns.


Let’s break down each of the three alternative investments, their potential fit in a retirement portfolio, their benefits and drawbacks, and who is a good candidate to add these kinds of investments to their portfolio.


Private Equity


While retirement investors gain equity in a business by buying its shares on a stock exchange, they can also gain equity in a private business outside the stock exchange. This is called private equity. By investing in private equity, investors can access a wide field of investment opportunities not typically offered in public markets.


For every publicly traded company, there are more than 6,700 private businesses. So rather than competing for the same 1,500 stocks as everyone else, private equity may help you gain access to be a shareholder of a private business. The Canadian Pension Plan has a significant allocation in private investments, specifically private equity. In the 2022 annual report, it was disclosed that CPP had an allocation of 32% in private equity, which was higher than its allocation to the public markets.


Where does private equity fit within a portfolio?


Adding this allocation can be a viable complement to traditional stocks and other asset classes in growth-oriented investment portfolios. When used appropriately, private equity can diversify the overall risk-return profile of an investment portfolio. Work with your advisor to decide the optimal allocation of private equity within your portfolio based on your investment goals, risk tolerance, and objectives.


Private Credit


This asset class is broadly defined as negotiated loans that take place outside of the traditional bank network and are held by private companies. Providing investors with more senior secured positions in the capital stack has made private lending an attractive option for portfolio diversification.


With the tightening of bank balance sheets, private credit has started to become a more critical part of the lending system. As an investor in private credit, you may position yourself to benefit from the rise in rates paid by borrowers.


Where does private credit fit within a portfolio?


This private asset can serve as a viable complement to a range of investment portfolios. When used appropriately, private credit can diversify the overall risk-return profile of an investment portfolio. It may be used to complement other fixed income and bond holdings to create a more robust fixed income asset allocation. Again, work with an advisor when deciding the optimal allocation of private credit within your portfolio based on your investment goals, risk tolerance, and objectives.


Private Real Estate


Private real estate offerings come in a variety of strategies and structures and typically involve income-generating properties such as residential, storage, student housing, and industrial buildings. These investments can offer investors a range of benefits, such as capital growth, stable cash flows, and access to select real estate opportunities that are not available otherwise.


In a way, this kind of investment allows you to own a piece of various kinds of physical real estate and benefit from the rental income and appreciation of the underlying properties.


Where does private real estate fit within a portfolio?


This asset can be a viable complement to publicly traded securities in different investment portfolios, ranging from income-oriented to growth-oriented. When used appropriately, private real estate can diversify the overall risk-return profile of an investment portfolio. Please work with a professional to help guide you in deciding the optimal allocation to private real estate based on your investment goals, risk tolerance, and objectives.


Key Takeaway


The key takeaway is that private equity, private credit, and private real estate are meant to complement a traditional portfolio by adding greater diversification, lower correlation, and providing a better risk-adjusted rate of return.


For a retirement investor, adding alternative investments to a retirement portfolio may decrease the swings in your portfolio, reduce drawdowns, and create more consistent income streams for an overall more satisfying investor experience.


As an investment advisor, I have seen firsthand how adding these kinds of investments can add value to an overall retirement portfolio. But, as with any investment, there are always risks involved. Here are a few key considerations:


1. Concentration Risk – Are all of your eggs in one basket? Some exempt market dealers structure private investments that allow individual accredited investors to buy into things like car washes, real estate, or student housing. While these are private assets, you don’t want all your money in one asset. Look for a provider that utilizes a sub-advisor model that will add diversification within each private asset class. We call this Accessible Multi-Manager Private Securities or AMMPS. AMMPS use best-in-class thinking to uniquely structure pools of private securities using an institutional approach.


2. Due Diligence – In public markets, information on a company is public. This is not the case for private companies. Complete your own due diligence and work with a team that uses a comprehensive due diligence process throughout the investment life cycle. These safeguards are crucial to protect the investor.


3. Liquidity – Private investments are less liquid than securities traded on public markets. This is due to the long-term nature of the investments and the lack of secondary markets. For the retirement investor, this highlights the importance of creating a retirement income withdrawal strategy that considers how the retirement portfolio is invested.


4. Access – To access these investments, you need to be an accredited investor. To qualify, you must have a personal income of over $200,000 or household income over $300,000 for two consecutive years, OR $5 million in net assets, OR $1 million in financial assets.


Who is a Candidate?


As with any investment, your risk tolerance, risk capacity, and timeline are key factors. Adding private investments to a well-balanced portfolio is suitable for nearly all investors. If you aren’t an accredited investor, there is a solution called “Pension-Style” investing.


This option utilizes private assets in combination with traditional investments that are accessible to accredited and non-accredited investors alike. You can learn more about this investment approach on episode 16 of the podcast or by visiting our website.


And there you have it, your brief introduction to the world of alternative investing.


Action Items for Today’s Episode


First, explore your options. With the sharp rise in interest through 2022, retirement investors watched as their traditional portfolio of publicly traded companies and fixed income both had negative returns. This prompted many to start exploring their options to diversify a portion of their portfolio for years to come. You should do the same.


Lastly, know what you are getting yourself into. Be sure to do your own due diligence and work with a team that has internal safeguards and processes that continuously monitor your portfolio throughout the investment life cycle.


Ok, that will do it for today’s episode. For the links and resources discussed, please check out the link in the show notes or visit retiringcanada.ca. If you enjoyed the show, please subscribe and leave us a 5-star review on your favorite podcast app. Be sure to sign up for my weekly Retiring Canada newsletter.


And hey, when it comes to your retirement, don’t take chances.


Make a plan so YOU can retire with confidence.


McKinsey and Company, Oct. 20, 2021. Reports of corporates’ demise have been greatly exaggerated; ICSID.org, Nov. 6, 2021, How many private businesses are there in the United States? 


All comments are of a general nature and should not be relied upon as individual advice. The views and opinions expressed in this commentary may not necessarily reflect those of Harbourfront Wealth Management. While every attempt is made to ensure accuracy, facts and figures are not guaranteed, the content is not intended to be a substitute for professional investing or tax advice. Please seek advice from your accountant regarding anything raised in the content of the podcast regarding your Individual tax situation. Always seek the advice of your financial advisor or other qualified financial service provider with any questions you may have regarding your investment planning.  

 

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