This alternative to stocks and bonds is gaining a following among wealthy investors
I hear a lot of the following these days:
“The stock market is too volatile and there is a recession coming. I am nervous about stocks.”
“With interest rates so low, I will lose money owning bonds after tax and inflation.”
“Preferred shares have not performed very well over the past few years so I don’t want those.”
What often comes next is a question similar to, “If I don’t want to put money into those, do you have anything else you might recommend?”
As it turns out, we do have a lot that we would recommend, and it generally comes under the category of “alternative investments,” which are not publicly traded on markets. Most of the investments that we have in this area have been providing steady returns in the six per cent to 10 per cent range annually over the past several years.
Before you think that these are some strange and extreme types of investments, it is worth noting that according to Benefits Canada, almost 40 per cent of Canadian pension plans are now invested in alternative investments. The plan managers are doing this for all of the reasons raised in the opening three quotes. They are worried about volatility and risk-adjusted returns from stocks. They are especially concerned that in a low interest rate world, the plans can’t generate the required returns with only traditional conservative government or high-quality corporate bonds.
While alternative investments include infrastructure, commodities and private equity, much of our investment focus is in the areas of private debt and real estate. In a nutshell, private debt is lending that is not done by traditional banks and does not include bonds traded on public markets. Ever since 2008, the banking landscape has changed and their lending strategy narrowed. This left many companies and individuals who required debt to look for alternative sources of funds. Over the past decade, private debt has grown over four-fold and is now close to US$1 trillion in assets globally, according to the alternative credit council. Our real estate investments, meanwhile, tend to be focused on managers that lend to developers and building owners and who have a global reach.
To help understand the increase in interest in alternative investments, and why the returns are higher than most publicly traded bonds, here are some examples of how private debt works. In some cases, the borrowers can be higher risk than traditional banks are comfortable with, but often the borrowers fall into a variety of buckets that banks can’t or won’t service for other reasons.
Examples include a business that requires a loan to close an acquisition. The business may be a perfect candidate for a loan but requires the funds in 3 weeks, while a traditional bank may take 3 to 6 months to approve it. Eventually the company may shift its borrowing to a bank at lower rates, but in the short term, the company is fine paying a high interest rate for the benefit of having the financing completed quickly. In other cases, a company may be in an industry that a bank may not lend to for reputational reasons, but which might otherwise be a great candidate for lending. For personal borrowers, sometimes they are business owners with a lot of assets and good credit, but low personal taxable income. A bank may not give them a mortgage but a mortgage investment corporation may think they are a great loan candidate, especially if they are only lending them 70 per cent of the value of their house, and the house is the first collateral on the loan.
In all of these cases, the borrowing rates would be higher, and often could be anywhere from six per cent to 20 per cent depending on the situation. It is these borrowing rates, along with strong risk management practices and full collateral that can provide steady returns at rates much higher than public bonds. These represent just a few examples of the many situations where someone is willing to borrow at high rates, for the ability to get the lending that they require.
The benefits to the investor are significant. First, they provide investment diversification and very low connection or correlation to the stock market. Second, over the past five years (as many funds were not around prior to this), returns have been quite steady with very low downside volatility. Having said that, a full investment cycle of 10 to 20 years would probably provide a little better test. And third, returns are often relatively high, with many funds providing returns in the six per cent to ten per cent range.
The main negative to private debt investments is that they are not very liquid. While publicly traded securities are often easily sold daily, many private debt investments might require anywhere from 30 days to a full year to redeem. This is one of the main reasons why private debt might only be one component of an overall portfolio. Because the risks on lending are often only as strong as the operational skill of the manager and the security against the loan, it is important to be able to assess whether any particular manager has top level skills to minimize the risk of losses.
While every person is different, in the 2019 investing world, we often have 10 per cent to 35 per cent of a clients’ overall portfolio invested in a diversified mix of private debt and other alternative investments. If your portfolio is 100 per cent invested in publicly traded investments, it is worth noting that many wealthy individuals and most pension plans believe that you are making a mistake. Now may be the time to consider looking beyond traditional investments to meet your long-term goals.
Ted Rechtshaffen, MBA, CFP, CIM, is president and wealth adviser at TriDelta Financial. He is hosting a webinar with Canadian industry leaders on alternative investments later this month. To attend, click here.