With equity markets reaching all-time highs and bonds offering low yields, it may be time to start preparing for an eventual downturn, Richardson GMP says in a weekly Market Ethos report. Alternative strategies are one option.
While alternative investments include futures trading, private equity, real assets, long-short equity, bond strategies and more, the Richardson GMP report recommended thinking about them in terms of their impact on the overall portfolio.
The report offered three groupings: capital growth, credit/income and volatility management.
Capital growth, the most volatile group, includes private equity, venture capital, concentrated long portfolios and some long-short strategies.
Credit/income uses long-short credit, alternative lending and private debt to find yield in a low-rate environment.
Volatility management reduces risk with long-short and market-neutral strategies, real assets and futures trading. The strategies offer low correlation to the market and strong downside protection.
For this reason, the report said volatility management strategies are best suited to this point in the market cycle.
“While there are numerous volatility management solutions, all with their unique benefits, alts — notably the volatility management strategies — typically lose less than the overall market. Some even generate their best returns during market meltdowns,” it said.
However, the report warned that alternatives aren’t a cure-all. The strategies have higher fees and, in many cases, recent performance hasn’t warranted the costs. With a limited track record and less oversight, alternative strategies require more due diligence than other assets, the report said.
“While having access to unique investment strategies has the allure of greater sophistication, failure to adequately understand these strategies can lead to disappointing results,” it said.
The performance variance between top- and bottom-quartile managers is also much more significant than in other assets — 7% for hedge funds and 14% for private equity, the report said (compared to 0.5% for bonds and 2% for equities).
Richardson GMP stated that there’s no single appropriate allocation for alternatives, as investors’ goals, tolerance and portfolio size all matter. The firm generally allocates 10% to 20% of a portfolio for those seeking to adopt alternatives. On the higher end, this moves 8% from bonds and 12% from equities in a traditional 60-40 portfolio, for a 48-32-20 split.
The introduction of liquid alternatives on Jan. 1, 2019 provided a more affordable option for Canadian investors. As of September, $4.5 billion was invested in 60+ products, the report said.
While the products are expected to gain share in the coming years, Richardson GMP warned about solutions “akin to fitting a round peg in a square hole.” While some managers offer strategies that fit well within liquid alt rules, the report said, investors should be wary of those whose offering memorandum had to be “drastically modified” to meet the criteria for liquid alts, as well as those launched to ride early momentum.