Looking For Yield? Look to Alternatives—And Build an Alternative Approach
From our perspective, the traditional way of putting together an income-generating portfolio is a little bit backwards.
Most advisors start with an allocation to different asset classes and then fill the “buckets” with specific investments. We go the other way: we start with a universe of strategies, analyze each on the basis of returns, volatility, and correlations, and then build a portfolio that combines them in a way that we believe will best meet our clients’ objectives.
In practice, that means going outside of the traditional stocks-bonds paradigm and into alternatives, which can be especially useful for generating income in the current environment. That said, how you implement alternatives in a portfolio makes a big difference, as you want to generate extra income without subjecting your portfolio to unnecessary risks.
What are alternatives?
Investors often ask this question, and it’s a reasonable starting point.
When we talk about alternative sources of income, we’re looking outside of traditional bonds. We might consider options like private lending, mortgages, or even suitable hedge fund strategies. For investors who need ready access to capital we might look towards liquid alternatives, a class of products that often use “hedge fund-like” strategies in a way that’s more accessible.
Overall, our view is this: any asset class or strategy could produce income, and the idea is to find the combination that produces the income you want with the minimum amount of risk to the investor.
Start with the quantitative test—not the asset class test
Again, we believe it’s useful to start the process with a single large bucket of possible strategies, rather than trying to fill smaller buckets of stocks, bonds, and alternatives. That way, we can use whatever combination of investments makes the most sense from a risk and returns standpoint.
The diligence process within strategies, however, is just as important.
We want to know as much as possible about how each strategy works and how sustainable or risky it is. Risk management is an important watchword for investors, but it’s also a process that can be analyzed and understood. We value portfolio managers who have strong risk management protocols, and we spend a fair amount of time learning about each manager’s approach and vetting it against our own.
Develop relationships with high quality managers
This is obviously easier said than done, but when allocating assets to a manager, it’s important to have a high degree of confidence not just in the strategy but in the ability of that manager to be discerning, careful, and responsive to changes in the market environment.
The pandemic was a great test for this.
What we want to see in a situation like 2020 is the ability to anticipate and respond to changes in market conditions. For example, one mortgage lender we use reworked their strategy in Florida once it became clear that COVID-19 would have an impact on demand for multi-family homes. We felt this was an appropriate shift, and so far we’re happy with the results.
There is no pitch deck that can really answer this question. We want to see a track record and a way of thinking. That takes time to learn about and requires a lengthy diligence and relationship-building process.
Understand capacity limitations
In any asset class or strategy, there are capacity constraints. For something like large-cap equities, the capacity is very high, but for a more focused strategy, like a particular type of private loan, the capacity might be very low. If too many investors flock into that strategy, it may no longer produce the results we’re seeking.
This is where it can be extremely helpful to be a small, nimble firm. Large institutions generally have to look at strategies with very large capacities in order to accommodate all their clients; we aren’t constrained by that.
We can take advantage of lower-capacity strategies, and in general we favor them. It’s our view that niche strategies are capable of delivering outperformance without subjecting investors to unnecessary risks—but they do need to be well understood and selected carefully.
Working with an advisor to manage alternatives
If you work with a wealth advisor who is allocating funds towards alternative investments, we strongly recommend that you spend time asking questions about these processes and potential issues. Alternatives can help to provide income and consistency in a portfolio, but we believe they need to be well-applied and well-researched in order to be effective.
It’s also important to get an understanding of how agnostic your advisor is in using alternatives. Low yields won’t be around forever, and situations evolve. At some point, another combination of strategies might be more advantageous to you as an investor. The ability to adapt to these kinds of changes is important, as is the willingness to let go of a strategy you might like in favour of one that might work better.
All said, we don’t just recommend allocating to alternatives, we recommend a strategy that starts with an objective, incorporates a lengthy diligence process, and ends with a portfolio that potentially helps you meet your objective in the most advantageous way possible.