Many advisors are turning to alternatives to add stability amid volatile markets.GETTY IMAGES
Karac Graham often turns to liquid alternatives to help steady his clients’ portfolios. For instance, a market-neutral strategy can account for 5 per cent to 10 per cent of a portfolio in his advisory practice. That gives his clients a dependable source of diversification with low correlation to conventional holdings.
This approach reflects how many advisors are looking to ensure portfolios can withstand volatile public markets, layering in alternatives that deliberately seek return drivers apart from stocks or bonds.
“Every investor should have alts in their core holdings,” says Mr. Graham, associate investment advisor with Moyle Rowley Wealth Management Group at Wellington-Altus Private Wealth Inc. in Barrie, Ont.
The case for alternatives was made clearer by the simultaneous declines in publicly traded equities and fixed income in 2022, says Rob Poole, co-head of equity strategies and portfolio management and trading at Toronto-based PICTON Investments. That rare but painful occurrence has triggered an appetite among investors for additional sources of portfolio stability.
Alts range from trading strategies such as the kind Mr. Graham uses, to asset classes spanning private markets, to direct exposures to commodities and precious metals. Building a lasting allocation requires understanding which exposures can support returns and which can help contain the swings.
Mr. Poole separates alternatives into two groups: “enhancers” and “diversifiers.” He defines enhancers as investments that may have the same or similar risk profile as another investment in the portfolio, but can provide a higher rate of return. Diversifiers are less correlated assets, which aren’t as reliant on consumer spending or the economic cycle.
As examples of enhancers, Mr. Poole points to private equity and private credit. Private equity can expand access to business growth and offer potentially higher compensation for committing capital over longer periods. Private credit can supplement income at a premium to public bonds for similar reasons.
However, both retain some connections to public market risks, Mr. Poole cautions.
“It’s not like you’re 100 per cent uncorrelated, but you’re maybe providing an enhanced return stream to a public market portfolio.”
Meanwhile, he says infrastructure and real estate, two sub-asset classes that generate cash flows from regulated revenue and rents, can play the role of diversifiers.
There are also trading strategies to consider. Mr. Graham favours market-neutral to limit broad-market exposure through offsetting equity positions. He also likes merger-arbitrage allocations, which pursue returns linked to vehicles that invest in corporate transactions.
In recent years, the introduction of many new liquid alternative funds and evergreen private-market vehicles to the Canadian market has widened the choices available to investors. That has also introduced new risks.
To start, redemption terms can differ substantially. Although a market-neutral holding offers daily liquidity, many evergreen private market structures restrict withdrawals. Investors able to commit money for longer periods may have greater patience for such structures, which allocate heavily into private equity and credit.
“If you have a long-duration portfolio, similar to what you would view as a pension fund, you may be open to taking on more liquidity risk and adding more enhancers to your portfolio,” Mr. Poole says.
Those seeking less volatility but emphasizing liquidity may look to liquid alt strategies. Mr. Poole supports a starting framework of 40 per cent equities, 30 per cent fixed income and 30 per cent alternatives, with adjustments for the investor’s circumstances. Mr. Graham targets approximately 20 per cent in alternatives, while tailoring the underlying mix.
For Mr. Poole, liquidity provisions in private markets alts are paramount for individual clients and investors. He says redemption limitations can protect investors by reducing pressure to sell assets, but they leave those seeking withdrawals unable to access their money.
“Even though some may be marketed as semi-liquid, when you need liquidity, you may not always be able to get it.”
Another point of caution is the appearance of steadier returns. Private assets valued less frequently may appear to be insulated from declines in public markets even though their underlying businesses face similar pressures.
Mr. Graham looks for cash flows that support valuations and asks whether those valuations are updated independently. Fees require scrutiny. Clients may accept higher costs for risk reduction, but the portfolio benefit must justify the expense, he says.