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For today’s Soundbites, we discuss alternative investments with Chris Koltek, institutional client portfolio specialist, with Portfolio Solutions Group, a division of Canada Life Investment Management. We talk about the wide range of alternatives out there, liquidity risks and the complexity of investing. And we started by asking if economic conditions are right for a move to alternatives.

Chris Koltek (CK): In our view, yes, especially for alternatives such as real estate and private credit and other private securities. The environment that we’re in right now, with rising rates, higher inflation, and extended valuations in many public markets, creates a strong opportunity for the benefits of alternatives. So, for example, greater inflation protection, potential income enhancement or yield enhancement, potential downside protection and capital preservation — these are really all strong benefits in the economic conditions that we find ourselves in today. We believe these are compelling reasons for investing in alternatives right now. But what really interests us is the diversification and differentiation that alternatives can provide throughout a market cycle. So, for example, real estate has provided an alternative income stream throughout different market cycles, and over time can benefit from capital appreciation as well.

Proportion targets.

CK: A typical allocation for us would be about 10% or 20% for global alternatives, with the more illiquid alternatives being closer to 3% to 7% of portfolios. It really depends on the type of alternatives being used for us. So, in Canada we actually have regulatory guidelines of no more than 10% in liquid assets. Instead of just applying this rule generally, we tend to go a step beyond these guidelines and consider what would occur in a stressed environment in terms of returns, volatility, correlations and liquidity for example. So compared to a normal market environment, we’d want to adjust the alternative ratings with this mind. Different types of alternatives tend to have different risk-and-return profiles as well, which can really help to improve the diversification within the portfolio. That said, they’re not a one-sided coin. They come with risks as well. So due diligence and appropriate size of allocation is really important to us. You have to consider what would be happening in the context of the rest of the portfolio and the relationship between the alternative — or alternatives — and the rest of the investments, especially when it comes to the characteristics such as liquidity. This is really a key risk with alternatives, and one that you can’t overlook. For many alternatives, it’s really going to come down to if there’s a secondary market, or if it’s a pool or a fund, is there a cash component to provide liquidity for the investors. You know, if there is a secondary market, you can go out and sell it to another individual or another company. And if it’s a pool or a fund, hopefully you’ve got a cash component there, and the cash component is designed to provide the liquidity of the investment. The issue is that there is some investment structures and terms out there that are locked in. And you can be locked in to periods of five, 10 years without liquidity.

Where alternatives really deliver.

CK: As part of a strategic mix, alternatives have provided strong protection in the past. If you look at 2021, that provides a great example where we saw positive returns out of fixed-income alternatives, such as the private credit market, while traditional fixed income indices declined. Also, over the long term, real estate has really helped bring down overall volatility of a portfolio and has the potential to increase risk-adjusted returns as well. So, if an alternative can protect the portfolio on a downside, that can really help increase returns during periods of market stress.

Risk management with alternatives.

CK: I’d say alternatives can be more complex and less transparent than traditional asset classes in public markets. So, the due diligence process really becomes a priority. The excitement of alternatives can lead people to extremes. It can be easy to be too tempted by something that looks unique, distinct, and special, and over-allocate to it. It’s also easy to dismiss an alternative because of the lack of liquidity, its complexity or a bad previous experience. The challenge is really to build a professional investment process with guardrails or constraints where various alternatives can play a specific role in the portfolio. So, as an asset allocator, from a risk management perspective, I’d say alternatives require a high level of due diligence to truly understand the composition and potential impact on portfolio. But above all else, I would say success with alternatives requires a strong and disciplined investment process.

Well, those are today’s Soundbites, brought to you by Investment Executive and powered by Canada Life. Our thanks again to Chris Koltek with Canada Life’s Portfolio Solutions Group.

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