Economic conditions creating strong opportunities for alternatives

Economic conditions could be right for a move to alternatives, says Chris Koltek, a portfolio strategist with Canada Life’s Portfolio Solutions Group.

He warned that alternatives tend to be more complex and less transparent than traditional asset classes, but they bring advantages that suit the moment.

“The environment we’re in right now — with rising rates, higher inflation, and extended valuations in many public markets — creates a strong opportunity for non-traditional investments,” he said.

Speaking on the Soundbites podcast, Koltek said the benefits of alternatives include inflation protection, potential income enhancement, downside protection and capital preservation.

“These are all strong benefits in the economic conditions that we find ourselves in today,” he said. “But what really interests us is the diversification and differentiation that alternatives can provide throughout a market cycle.”

For example, real estate helps bring down overall volatility over the long term, while also offering increased risk-adjusted returns, alternative income streams and capital appreciation throughout different market cycles, he said.

In a similarly positive vein, fixed-income alternatives such as private credit saw positive returns in 2021 while traditional fixed-income indexes declined.

“When you have an environment where you have lower expected forward-looking returns, alternatives can offer compelling risk-adjusted return opportunities,” he said.

Proportion targets

Koltek is particularly mindful of illiquidity.

“This is really a key risk with alternatives, and one that you can’t overlook,” he said. “If there is a secondary market, you can go out and sell to other 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 are some investment structures and terms out there that are locked in. And you can be locked in for periods of five, 10 years without liquidity.”

He manages liquidity through asset allocation. His informal rule of thumb is 10% to 20% for more liquid alternatives, and about a third of that — 3% to 7% — for illiquid alternatives like commodity futures and global quantitative funds.

“Different types of alternatives tend to have different risk-and-return profiles,” he said. “So due diligence and appropriate size of allocation is really important to us.”

“The excitement of alternatives can lead people to extremes,” he said. “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 to build a professional investment process with guardrails in place, where alternatives can play a specific role in the portfolio.

“You want to have a look at the overall context of the investment. You have to look at the qualitative factors as well like the diversification in terms of sources of income, or potential political or liquidity risks,” he said. “A few holdings can really change the dynamics of the entire portfolio.”

Therefore, alts require a high level of due diligence to truly understand their composition and potential impact.

“Above all else, I would say success with alternatives requires a strong and disciplined investment process,” he said.

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This article is part of the Soundbites program, sponsored by Canada Life. The article was written without sponsor input.