Why private alternatives are the future of asset allocation

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Private real estate has shown tremendous benefits. At the height of the pandemic, private multi-family residences performed well and did not experience the decline of public real estate.SvetaZi/iStockPhoto/Getty Images

Over the past two decades, there has been a fundamental shift in conservative capital investment philosophies. Pension, endowment and ultra-high net worth fund investors have allocated more of their assets to alternative investments due to chronically low bond yields, central bank intervention and the threat of exorbitant stock market valuations .

Investors have been told for years that diversification improves portfolio stability, but diversification itself has taken on new meaning. The COVID-19 pandemic along with the recent retail frenzy has revealed a series of “winning” and “losing” asset classes, as well as the unparalleled and consistent performance of one particular asset class: investments. private alternatives.

Although alternative assets are not new, they are still considered untraditional and unconventional by many investors. Nevertheless, there was a clear sign from institutional investors in 2020: as long-time believers and believers in the alternative space, they prioritized even heavier allocations to these investments.

This is due to the performance of this asset class and the consensus that the alternatives will deliver higher yields and meet future obligations, while being able to hedge against excessive downside risk. This is an indication for retail investors to follow suit.

After all, if pension and endowment portfolio managers are using private alternatives for these reasons, shouldn’t Canadians approach their retirement savings with a similar philosophy?

Consider the advantages that alternatives offer to investment portfolios. First, they have a low correlation to public equity markets and traditional fixed income securities. In addition, private alternatives generate consistent returns with lower volatility, protect portfolios against major declines or losses, and offer better risk-adjusted returns.

Moreover, an optimal portfolio is a portfolio that is well diversified and includes other sources of return. Portfolios must include companies from different sectors and countries to be considered truly diversified.

Within the catch-all term private alternative investments, there are three sub-categories that have proven to offer the best risk-adjusted returns: private debt, private real estate and private equity.

Private debt, which are privately negotiated loans outside of the Tier 1 financial system, provides investors with secure senior positions in the capital stack, making private loans an increasingly attractive option for diversification of capital. portfolio because it offers equity-like returns without volatility.

Let’s look at the volatility caused at the start of the pandemic. Traditional asset classes such as core fixed income, for example, traded 5-10% lower, while private debt yields remained positive.

With bond yields at historic lows, traditional fixed income securities will continue to lag in the near term. If inflation returns and interest rates begin to rise, this could lead to further challenges, leaving the fixed income market likely unattractive for the foreseeable future. This makes private debt a viable option for investors seeking security and yield.

Private real estate, like private debt, has also shown tremendous upside, particularly in the key areas of multi-family residential, industrial and self-storage. All are poised to continue to perform well over the course of the year.

At the height of the pandemic, private multi-family residences performed well and did not experience the decline of public real estate.

In the industrial space, retail and data centers are hot due to e-commerce demand, and inventory isn’t expected to stabilize anytime soon. Finally, capitalization rates on storage are much higher than on multi-family residential. This can be expected to compress, resulting in good capital growth.

Overall, this shows why most institutional investors typically allocate 10-20% of their assets to private real estate.

Private equity is typically the largest component of a private alternative allocation for institutional portfolios. It looks like the capital commitment will continue. According to Preqin Ltd., which provides market data and information on alternative assets, private equity will be the fastest growing alternative asset class through 2025.

Cautious investors have been biased towards this asset class as it has demonstrated an ability to outperform public equities, even in declining markets, with less volatility. Although the private equity industry is not immune to recessionary environments, it has proven to be more immune to sensationalism and irrational investor behavior than public equity markets.

Today, more companies than ever are choosing to wait longer to go public, ultimately coming to market at a better valuation. For example, Uber Technologies Inc. UBER-N came to market with a value of over US$80 billion. As an investor, wouldn’t it make sense to be an owner when this 80 billion US dollars was created privately?

The long-held belief in the investment community is that taking on more risk (measured by standard deviation) results in increased returns. However, the data is certainly starting to look against that. Incorporating a healthy allocation of 20% or more to alternative assets such as private debt, private real estate and private equity simultaneously reduces risk while increasing returns.

As more and more Canadians approach and enter retirement and begin to dip into their investment savings, finding the best risk/return balance is paramount to portfolio success.

Investing in private alternatives is investing like a pension. This approach has proven to be prudent, as it has generated probable and predictable results, ultimately improving the retirement of Canadians.

Travis Forman is Senior Vice President, Portfolio Manager and Investment Advisor at Harbourfront Wealth Management in Surrey and Kelowna, BC.

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