Finding the Balance in Diversification

Famed American stock investor Philip Arthur Fisher once said: “Investors have been so oversold on diversification that fear of having too many eggs in one basket has caused them to put far too little into companies they thoroughly know and far too much in others which they know nothing about.” In a similar vein, one of if not the most famous investor of our times, Warren Buffet, said wide diversification is only required when investors do not understand what they are doing. Pension funds have long been a global market leader in terms of allocations to some alternative asset classes, particularly infrastructure. Why? The underlying economic climate is changing: the equity cycle may be approaching a peak, asset prices and valuations everywhere appear pricey, and interest rates are unlikely to stay low. Pension funds realize that there is often better value and certainty in this value of alternative asset classes than publicly listed companies - equity and debt.  Well run funds like the Canada Pension Plan and the Ontario Teachers’ Pension Plan have moved strongly toward alternatives.


What are alternative investments?

Broadly speaking, alternatives are generally investments in assets other than traditional stocks, bonds and cash. While many investors immediately think of hedge funds when they hear the word “alternatives”, this is not what we are referring to here. We are referring to private investments in either debt or equity; private debt is where the investor is lending money and private equity is where the investor owns some asset(s), e.g. a company or real estate development, etc. Private investments are chosen primarily for their non-correlation with traditional investment vehicles and higher expected returns. Since they are not commonly traded, they are not listed on public exchange, generally making them illiquid. Adding them to a portfolio may provide broader diversification, reduced risk and enhanced returns, however typically with less liquidity.


How does Private Debt and Equity work?

Some investors still think of alternatives as high-risk, exotic hedge funds reserved for ultra-high-net-worth individuals and institutions. The reality is that private debt and equity investments can be an integral part of nearly every investor’s portfolio based on their objectives and risk tolerance.
 

Myth: Private investments are more volatile than stocks and bonds.
Reality: While some hedge funds have experienced higher levels of volatility in the past, private debt and equity investments do not necessarily share the same volatility characteristics. Portfolio Stewards seeks private investment vehicles that provide lower expected volatility relative to the stock market.

Myth: Investing in one private debt or equity transaction will diversify my portfolio.
Reality: Just as adding one stock or bond does not lead to significant diversification, adding a single private debt or equity deal may have a similar limited impact. Investing in only one private investment may also increase concentration risks.


Myth: Investors cannot access their money on a timely basis
Reality: While liquidity is typically less for private debt and equity investments, people should plan their cash-flow needs and think about where it will come from.  Publicly listed securities are often the preferred place to meet unanticipated liquidity needs, but most people do not require immediate liquidity in all of their investments (i.e. their home). Also, private securities with different liquidity time horizons can be paired together; i.e. combine private funds that have a one-year liquidity restriction with investments that have a 2-3 year liquidity horizon and 5+ years liquidity.


Myth: Only institutional and ultra-high-net-worth investors can access private investments.
Reality: In 2015, Portfolio Stewards began exploring private debt as an alternative to historically low yield in bonds.  Since then, we have added private debt funds to our fixed income across the majority of our clients’ accounts.  In both 2018 and 2019 we were finalists in the Canadian Alternative Advisor Awards.


Myth: Private investments have failed to protect investors during market downturns.
Reality: History shows that private investments typically have not fallen as far as stocks, thereby providing a cushion for investors. This low to no correlation to stock and bond markets is at least partially due to their illiquid nature, insulating private investments from panic selling.


Myth: Private Investments are too expensive.
Reality: The fees for alternative investments vary and depend on the fund’s structure. Granted, the majority are expensive relative to low-cost ETFs; however, Portfolio Steward's due diligence will assess whether or not the investment benefits to clients will outweigh the added costs. 

 

How can I use private investments?
Investors should choose alternatives that align with their distinctive goals, which may include mitigating stock market volatility, lowering correlation to traditional markets, investing capital for a longer time frame in exchange for higher return potential, and hedging a portfolio against inflation or rising interest rates.

 

Emma Lynch, B.Comm, CA (Aus)
Wealth Counsellor