Invest Well. Live Well: How does big money invest?

In recent years, institutional investors such as university endowments, pension funds and sovereign wealth funds have shifted their asset allocation away from standard investment classes like stocks and bonds and into alternative investments such as private debt/equity, hedge funds, real estate and infrastructure.

This suggests they either believe that alternatives can earn a higher return, have lower risk or provide diversification benefits. 

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Most college and university endowments in the United States voluntarily report to the National Association of College and University Business Officers (NACUBO). In 2020, 705 institutions representing $638 billion reported the following average portfolio allocation: 

• 12% income (bonds)

• 33% public securities (stocks)

• 23% private equity and debt 

• 20% alternative strategies (hedge funds)

• 11% real assets (real estate and infrastructure)

Most investors are familiar with stocks and bonds. Note that less than half of the portfolio is held in these classic formats. Given government bond yields are well below two per cent, it makes sense to explore other investment options. 

In past articles, we have written about the benefits of private debt (mortgages) and real estate. We want to focus on hedge funds, which have a wide range of strategies — from conservative to aggressive — and often make use of sophisticated tactics, including options, futures, currencies, leverage, stop-losses, shorting and many other tools that mutual funds typically cannot employ. 

Hedge funds, while sometimes difficult to assign to specific categories, tend to fall into one of the following:

• Long-short: long, favourable companies and betting against those with poor fundamentals

• Market-neutral: hedging against up or down movements

• Event-driven: “quick-trigger” decisions to attempt to capitalize on anticipated news

• Macro: betting on overall market trends

• Arbitrage: looking for mispricing of securities, possibly in merger situations

• Distressed: purchasing potential insolvent or bankrupt securities 

Some hedge funds are more aggressive and will borrow (leverage) thereby magnifying their results. In addition, many strategies have higher minimums and liquidity restrictions where you might have wait up to a year to get your money out.

Often, a hedge fund will set an “absolute return” objective. For example, strive for a five per cent return in all market environments. The goal is to deliver positive returns throughout various market conditions. Given the 2008 financial crisis and the pandemic, many investors are looking for alternative ways to reduce risk and protect the downside. Depending on your investment objectives and risk tolerance, hedge funds can be a good diversifier to a portfolio. 

As for costs, the norm in the industry is to charge a management fee plus an incentive or performance fee. For example, a hedge fund that made eight per cent could have a one per cent management fee, as well as a 20 per cent performance fee. The result is 1% + 1.4 = 2.4% in fees leaving investors, with a return of 5.6 per cent.  As you can see, costs can seriously detract from what ends up in the investor's pocket.

For all the reasons mentioned above and more, the alternative space and hedge funds are incredibly difficult to navigate. In addition, regulators and compliance departments typically classify these strategies as higher risk due to the  added complexity.

We strongly recommend that investors work with an experienced advisor or portfolio manager to determine the best fit for their wealth within their comfort and to ensure that they understand the potential rewards and risks associated with this type of investment.

Until next time, Invest Well. Live Well.

Written by Eric Davis. This document was prepared by Eric Davis, vice-president, portfolio manager and investment advisor, and Keith Davis, investment advisor, for informational purposes only and is subject to change. The contents of this document are not endorsed by TD Wealth Private Investment Advice, a division of TD Waterhouse Canada Inc.-Member of the Canadian Investor Protection Fund. All insurance products and services are offered by life licensed advisors of TD Waterhouse Insurance Services Inc., a member of TD Bank Group. For more information, call 250-314-5124 or email Keith.davis@td.com.

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