More than 20 years ago, foundations, endowments and pension plans could allocate 100 per cent to bonds because interest rates were over 7.25 and they could meet their short- and long-term objectives.
Currently, a 10-year government bond only yields 1.55 per cent, making it a challenge for institutions, as well as retirees. To overcome this, their portfolios need more money or different strategies.
Such institutions have invested in alternatives to improve the quality of their returns and enhance their diversification.
Alternatives (alts) can generally be broken down into three categories:
1. Private equity and debt: direct ownership of or lending to companies.
2. Real assets: stable businesses in real estate, infrastructure or resources.
3. Hedge funds: employ advanced strategies like options, futures, leverage, stop-losses, shorting, etc.
In technical speak, they desire uncorrelated and superior risk-adjusted returns. According to its website, the Canada Pension Plan has drastically changed since 1997, when it was 100 per cent bonds. In order to ensure long-term sustainability, today it sits at 11 per cent bonds, 39 per cent equity and 50 per cent alts.
In the United States, most college and university endowments voluntarily reported to the National Association of College and University Business Officers. In 2017, more than 800 members — which include notables like Harvard, Yale and Princeton — reported the following average asset allocation: cash (four per cent), fixed income (eight per cent), U.S. stocks (16 per cent), foreign stocks (19 per cent) and alts (53 per cent).
The alternative universe is a challenge to navigate because it is less regulated, less transparent and difficult to make comparisons. Many strategies have higher minimums and redemption periods of between three and 12 months. Furthermore, alts can only be purchased by a licensed portfolio manager or an accredited investor, which requires a minimum level of income, investable assets or net worth.
We focus mostly on private debt and equity because their prices tend to remain stable and they can provide steady income of five to eight per cent, paid monthly. Like virtually all investments, alts are not 100 per cent guaranteed and some can be risky and are not suitable for all investors.
Since the 2008 financial crisis, many banks have stricter guidelines. As such, businesses look to finance loans or mortgages from non-banks and in return provide collateral and/or personal guarantees. Among the most important criteria to the borrower is speed of execution and certainty the deal will be approved. The lenders typically look at the five C’s of credit: character, capital, capacity, collateral and conditions.
As the saying goes, it is easy to make a loan, but hard to collect. If a deal goes into default, it may be resolved quickly or it could deteriorate and require enforcement, which can lead to impairment (loss). Between 1998 and 2015, the private debt asset class loss rate was -0.7 per cent versus -2.8 per cent for high-yield bonds. This difference was likely due to enhanced security, covenants, control of the recovery process and an information advantage. Private lenders typically have boots on the ground and a deep understanding of the borrower's financial situation, demographics, economics, real estate laws, governments, etc.
We feel investors should take a hard look at their portfolio mix now as we believe we are in the late stages of the business cycle. In addition, we recommend investors work with an experienced portfolio manager to help build a more diversified and resilient portfolio for today’s world.
Until next time, invest Well. Live Well.
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.email@example.com.