Today’s investment environment, characterized by low interest rates and historically higher asset valuations, presents a challenge for investors, particularly those faced with the task of balancing their needs to generate income and growth, with managing risk to protect their capital. Specifically, in the quest for yield since the credit crisis, there has been a trend towards investments in asset classes outside traditional fixed income and equities. Waiting on the sidelines is also not a luxury for income driven investors as cash yields next to no return.
While broadening your exposure into other assets classes may be necessary in order to meet your goals, there are steps you can take when venturing further out the risk spectrum to limit the overall risk to your portfolio. To accomplish this requires a deep level of analysis. Within each asset class you evaluate, you should endeavour to understand the various market factors at play that could negatively impact your investments (the ‘risks’), and more importantly, ask yourself how you can best position your portfolio to mitigate these risks (the ‘strategy’). Following this strategy will allow you to expand your investment universe with as little added risk as possible. We have outlined examples of this approach for a sample of asset classes:
Risks: Fixed income has traditionally acted as the safeguard of many investors’ portfolios, providing capital protection and predictable income. However, prevailing market conditions have made it difficult to enter the asset class or replace maturities. Because of the inverse relationship between bond prices and interest rates, the main concern for fixed income investors is the possibility that rates could rise from today’s historically low levels. The most sensitive bonds to rate changes are those with longer term maturities and higher coupon payments. Even if booking a capital loss is not a concern because the investor intends to hold a bond to maturity, purchasing at today’s low rates could still mean that they end up caught with an investment that yields below inflation, after taxes have been considered.
- Shorten maturities – Buying bonds that are due to mature in the near term and pay lower coupons can help to limit interest rate risk. The compromise is a lower income stream as these bonds are typically priced higher as they are more in demand — although at current rates the tradeoff is low. For example, 30 year government of Canada bonds currently yield 2.09%, while 10 year bonds yield 1.39% – only a 70 basis point difference for an additional 20 years of risk!
- Focus on quality credit – There are also many sophisticated fixed income managers who seek to isolate interest rate risk and concentrate instead on credit attributes. These managers are experts in credit analysis and they buy and sell positions based on their view of current valuation levels relative to the underlying fundamentals of the issuer.
Risks: Historically, US equity investments have exhibited high average returns (vs. bonds), providing both capital growth and income in the form of dividends as well as liquidity to investors. However, after several recent years of rising stocks prices, today’s market levels are one of the main concerns for US equity investors at this time.
- Play defense – Invest in sectors that are more defensive such as consumer staples and health care. These areas tend to better weather volatile markets than more economically sensitive cyclical sectors.
- Focus on quality – Buy high quality, dividend paying stocks. Many of these companies are well-established, and have the liquidity to cover their dividend commitments and manage their debt in the event of a slowdown. While their valuations may temporarily suffer, many will likely maintain their dividend payout in the event of a pullback. For example, no Canadian banks cut their dividends during the credit crisis.
- Hunt for value – Following the value style of investing can also help to protect equity investments. Value investors look to take advantage of pricing inefficiencies and will only purchase a stock at a significant discount to what they calculate as the company’s intrinsic value based on its qualities. The difference between the purchase price and the intrinsic price is considered a margin of safety that acts as a buffer, preventing the investor from paying too much for the stock. During times of rising markets, value investors may find themselves holding cash in their equity portfolio in lieu of stocks as opportunities become harder to identify. A higher cash weighting can provide an additional layer of defense if markets fall.
- Diversify beyond Canada – Canada’s stock market is dominated by financial and resource stocks. Investors should look to the US and other international markets to gain meaningful exposure to the aforementioned less cyclical sectors.
Risks: Private equity is an excellent alternative for long term minded investors looking to earn excess returns. At the moment, the world of private equity is experiencing lower expected returns due to inflows of capital. On the buyout side, low borrowing rates and the growing number of participants in the space have sparked increased competition for deals. This has the effect of lowering projected returns as companies end up going to auction. There is also an abundance of cash chasing tech related venture deals with no proven revenue streams, rehashing memories of the tech bubble.
- Relationships are key – In our experience, one major key to success in the industry is to partner with firms that are experienced and have the people, connections and infrastructures in place to access deals that would otherwise be unavailable. Exclusivity prevents bidding wars, which can enhance returns. Managers that have cultivated relationships over time and have the capabilities in place to execute quickly tend to standout when markets are crowded.
- Diversify across markets, sectors – Investors should attempt to work with managers to build a portfolio with exposure across a variety of markets and sectors. For example, it would be preferable to hold a broader portfolio of companies, than one concentrated only on the energy sector given the current conditions for the space.
- Cash is king – Focus on funds buying later stage businesses that already have cash flows. Businesses with cash on hand are less likely to require additional capital infusions to work through their challenges.
Risks: Traditionally real estate has acted as an avenue for investors to earn income and also protect against inflation. However, finding an entry point has become quite difficult as it is also an area where asset prices can be sensitive to interest rates. Valuations used in the property acquisition process are driven by capitalization (cap) rates. The higher the cap rate, the better the expected annual return on the property when initially purchased, and the reverse is also true. These rates are based on a spread to the prevailing government interest rates, and so when rates are low, as they are today, cap rates are also compressed. Cap rates have also been recently pushed down as large institutional money managers such as pension funds and insurance companies have looked to real estate as a way to generate cash flows in excess of low fixed income yields.
- Keep it short – Because of their rate sensitivity, real estate assets can behave like bonds, falling in value when rates rise. One solution to this problem, and also similar to fixed income investing, is to invest in shorter term real estate opportunities. Options here include quick turnaround redevelopment projects and mortgages structured to provide temporary mezzanine lending facilities to high quality borrowers in need of temporary cash.
- Don’t speculate – Avoid lenders involved in offering loans for development or speculative land purchase purposes.
- Cash flows are critical – For any investments that are made in income properties which will be held for the long term, it is critical that the real estate generates predictable cash flows and is occupied by high quality tenants. This will help the portfolio survive more difficult periods.
- Diversify your holdings – It is also prudent to diversify by type of investment and geography. For instance, owning all of your real estate in one market such as the Greater Toronto Area will expose it to shocks in the local market.
Risks: For investors who have room for a low-liquidity component to their portfolio, these funds offer a way for investors to benefit from the billions that will be spent to support the world’s growing need for new and updated infrastructure (i.e. highways, bridges, water treatment facilities, solar facilities). These investments have extremely low liquidity, and this feature exacerbates the challenge of finding a price efficient entry point for projects. Large institutions are also favouring this asset class at the moment, which has pushed up prices as many deals end up in the auction process. This has weighed down potential returns on the asset class, for which periodic income distributions are the main contributor. Setting a yield in stone for periods as long as thirty years is hard to grasp for investors who believe interest rates will rise considerably over that time frame.
- Keep up with inflation – The infrastructure manager should ensure that cash flows from any prospective investment can be adjusted to reflect changing markets conditions. For example, usage prices for utilities investments should be tied to interest rates.
- Stay out of the limelight – Managers should also focus on projects where competition from larger industry players is low. Marquee infrastructure assets are likely to draw the attention of many bidders, leading to higher prices and lower returns.
Find your niche – Try to find a manager that has a competitive edge such as industry specific-knowledge and expertise that would allow it the advantage of participating in niche deals that others would be less likely to pursue.