After a long period of low interest rates led investors to search for yield in alternative investments, the risk calculus is beginning to change.
In the decade following the 2008 financial crisis, some investors were willing to take a pass on desultory bond yields by moving into illiquid assets with higher yields. The case for boosting the fixed income portion of portfolios was especially strong after the Covid recovery in 2020, with interest rates near zero and central banks indicating they would remain there for several years.
“It’s naive to think that alternative investments haven’t benefited from the regime that we’ve had, with interest rates declining and globalization,” said Victor Kuntzevitsky, portfolio manager with Wellington-Altus Private Counsel, at an event last week put on by the Canadian Association of Alternative Strategies and Assets (CAASA).
This year’s soaring inflation and the response from central banks has been brutal for bond markets, and the destruction of standard 60/40 portfolios may have added to the case for alternatives. But safe investments such as investment-grade bonds and GICs are now yielding more than 5%.
“Many alts won’t do well in this environment of high rates [and] de-globalization,” Kuntzevitsky said. “There’s a time to allocate to alts and there’s a time not to allocate to alts. In our view, now is a time in the markets when you should not be as allocated to alts as before. There’s opportunities elsewhere.”
Kuntzevitsky said it’s not time for advisors to dump their alternative investments. However, they should scrutinize their holdings carefully. With investors able to find safe 5% yields on public bonds, “the liquid side is hands down more attractive,” he said.
There’s also a lag in reporting on private investments compared to public markets, so investors may need to wait longer for the bad news to surface.
Private investments, most notably private credit, are also receiving more scrutiny after the fall of Bridging Finance Inc., which is under receivership and facing fraud allegations from the Ontario Securities Commission.
Speaking at the CAASA event, Craig Machel, portfolio manager and investment advisor with Richardson Wealth, said that case has affected the broader industry.
“We’ve all got to step up and due diligence has got to be better,” he said. “It’s got to be more timely and it’s got to be deeper. And fund manufacturers need to have deeper teams.”
Some private credit managers are also having a hard time managing redemption requests. The Globe and Mail reported last month that private mortgage lender Romspen had to freeze redemptions. Last week, Blackstone said it was limiting withdrawals from its private REIT.
Kuntzevitsky said one way advisors can evaluate risk in private credit funds is to scrutinize the companies that managers have loaned to in the fund. Another way is to diversify across strategies and managers. The risk in private investments is often on the operational side, he said, so diversifying across managers limits that risk.
Machel also said diversification is a key part of managing risk.
“You don’t want to get caught offside when clients need liquidity,” he said.
For clients looking for stability or to preserve wealth, he’ll diversify portfolios across several managers. “If clients want larger returns and are accepting of volatility, we’ll concentrate the portfolio a little more,” he said.
Despite the need for due diligence, Machel said he’s a big believer in alternatives for reducing volatility and providing more stable returns than the traditional 60/40 portfolio.
“The trade-off is you don’t get the big, juicy returns that the markets gave through Covid,” he said, but investors can avoid the huge dips and not suffer as much in years like the current one.
He acknowledged that “it takes work” to get some clients comfortable with alternatives. Advisors should explain the purpose of alternative investments and how institutional investors such as the Canada Pension Plan Investment Board and the Yale University endowment fund operate.
He also suggested beginning with basic products, such as a hedged public credit fund that eliminates some interest rate risk, to allow clients to get comfortable.
The case is still strong for alternatives, he said, with the outlook for public equities uncertain.
“Markets can move sideways for a long, long stretch of time,” he said. “You don’t get paid just to be in it as a traditional investor.”
However, some investors will prefer traditional vehicles now that public fixed income investments are yielding more and have more room to act as ballast for the portfolio again.
“There’s so much yield potential in easy, simple, liquid bonds — you don’t need to complicate your life,” said Phil Mesman, portfolio manager and head of fixed income with Picton Mahoney Asset Management in Toronto, in an interview.
He suggested there will be a rotation out of some of the “esoteric subsets” of fixed income and back into normal bonds.