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Why going beyond stocks, bonds can boost your portfolio.
Going beyond stocks and bonds can pay off
Perspective is everything, especially when it comes to defining risk. A person’s background and their experiences help shape this perspective but one psychological factor often has the greatest influence of all — fear of missing out (FOMO).
People hate missing out on opportunities. Seeing others prosper while being left behind can be harder psychologically than actually losing money. So it isn’t surprising that investors often chase recent performance, which can result in a highly concentrated portfolio loaded up on risk.
There are all kinds of extreme examples of this kind of returnchasing in today’s market, including cannabis, bitcoin, artificial intelligence, autonomous driving, Canadian housing etc. That said, we’ve even seen it with more simple allocations, such as the large flow into balanced funds heavily focused in the U.S equity market.
Many family offices and endowments have avoided this pitfall by deploying a multi-strategy institutional approach to managing their wealth. This means deriving investment-return objectives that are independent of those of others and determining if they are realistic in the context of the current environment.
Such a strategy frequently involves moving away from the traditional 60-per-cent equity and 40-per-cent bond portfolio to a five-pronged approach to diversification and risk-managed investing.
Dynamic Asset Allocation
There is all kinds of empirical research showing one of the best ways to manage risk is through asset allocation. It has to be dynamic, though, meaning having the ability to adjust the portfolio weightings based on the market conditions such as moving to a high cash weighting during periods of euphoria or conversely a high equity weighting during periods of capitulation.
This is not trying to time the market, but instead adjusting weightings based on the return-to-risk ratio of certain sectors or markets in order to prevent large drawdowns without giving away too much of the remaining upside.
Quality and Value
In a market loaded up on risk, value-based managers have been underperforming recently. Those who select lower growth and less expensive companies with strong balance sheets combined with robust earnings and cash flow have not kept pace with the managers focused on high-growth sectors, such as technology.
However, over the long term, quality and value have proven to outperform high growth, especially during market corrections.
Derivatives
Utilizing the futures and options markets can be a very effective tool when it comes to generating tax-efficient income and absolute returns to a portfolio. This can mean deploying simple strategies, such as covered call and put writing, to more complex trades designed to offer a level of predictability by narrowing down the potential return outcomes.
That said, we’ve found that this component of the portfolio tends to be more conservative in nature around the return profile, often yielding mid-single digit returns.
Alternatives
Alternative investments include those hedge funds that deploy strategies such as long/short or arbitrage to manage risk instead of those that are simply levered-long. While fee structures have been coming down, it is still a sector that is expensive to invest in, something many investors have a difficult time with especially given the messaging coming out of the ETF market.
However, we have found that if done correctly, these managers will more than prove their worth, resulting in superior risk-adjusted returns net of fees. In our experience, this outperformance is most pronounced when it comes to fixed-income securities.
Private Equity
For those with larger portfolios, having a component in the private equity market will help round out a well-diversified risk-managed portfolio. Since this allocation will often be locked away for five or more years, it leaves the investor with no choice but to think long and hard about the investment merits over the long term before making a decision. This is not necessarily a bad thing.
In conclusion, a five-prong approach means stepping away from what the average investor is doing and deploying an institutional approach to managing your wealth. While the method may cause a bit of discomfort at first, it has shown its merits—there are reasons it is a model that sophisticated investors often pursue.
Martin Pelletier, CFA is a Portfolio Manager and OCIO at Trivest Wealth Counsel Ltd, a Calgary-based private client and institutional investment firm specializing in discretionary risk-managed portfolios as well as investment audit and oversight services.