Adding more of the same is not the way to manage risk

Just like the saying ‘nothing in life is truly free,’ investment returns cannot be earned without accepting some form of risk. The goal of the smart money – those who have a better understanding of the market or access to information channels that a regular investor can’t easily get - as with most long-term investors, is to maximize returns without undue risk of loss.

So how does the smart money manage risk? In one word: diversification. It’s one of the most basic fundamentals of investment management. The single biggest influence on its total portfolio risk and return is how the smart money deploys their investments across a diversified set of asset classes.

The rationale for investing across multiple asset classes is supported by the modern portfolio theory, which shows that allocating funds among more asset classes helps to reduce risk, since the decrease in the value of one asset class could potentially offset an increase in another. This theory is at the heart of the investment philosophy of most endowments and pension plans and is embedded in their asset selection process. Over the years, institutional investors have realized that diversification for the sake of diversification may not actually provide their portfolio with any inherent risk protection.

For instance, adding 30 more companies to a diversified equity portfolio of 300 companies is probably going to have only a minor impact, if any, on the portfolio’s overall risk return profile. Historically, institutional investors turned to publicly traded fixed income instruments to dampen the volatility of their portfolios and to potentially improve their risk/return profile. However, although initially successful, this strategy normally pulled down the overall returns of their investment portfolio. This was especially true during periods of prolonged low interest rates.

Roughly, 20 years ago, in an attempt to improve returns while still maintaining targeted risk/return levels institutional investors began turning to alternative investments, which covers any asset classes other than publicly traded stocks and bonds.

Alternatives tend to behave differently than publicly traded stock and bond investments and, in most cases, adding them to an investment portfolio should provide broader diversification, which should reduce the portfolio’s overall risk and enhance its returns.

Once exclusive only to institutional investors and the ultra-high-net worth investor, alternative investments are now within reach for many Canadians. The flurry of financial innovation, introduction of more affordable products and revised regulations have now made them more accessible to everyday investors.

According to its 2018 Annual Report, the Canada Pension Plan Investment Board (CPPIB) which is responsible for the investments in the CPP, uses public market securities. But, unlike most investors who invest solely in public markets, that’s only about half of their investment portfolio. The rest is in alternative assets (or private markets) – like private equity and real estate.

Table 1

Table 1 outlines how the CPP Investment Board’s allocations to alternative assets has evolved since 2005.  Take a look at the last line in the chart, % of net investments. This indicates that in 2005, the CPP Investment Board had only 4.3% of the Canada Pension Plan invested in alternative assets. Today, however they have 50%. Ultra-high net worth investors and the largest endowment funds in the world have followed the same trend.

It’s not surprising then that the wealthy follow the smart money by having real estate as a significant holding in their investment portfolio.

In general, these investors like the idea of “hard” assets. That is, assets that they can see and touch. They are looking for the opportunity to receive a highly tax efficient regular income stream that also has as a capital appreciation kicker embedded in it. Historically, professionally managed income-producing real estate has been un-correlated to both the movements in and returns of the public equity and bond markets. This has made it a great way to add true diversification to a traditional investment portfolio while enhancing the portfolio’s risk-adjusted returns.