Welcome to advanced portfolio-building class.
Whereas the investment industry mainly uses stocks and bonds in portfolios, a few firms take a more complex approach that adds significant weightings in assets like hedge funds, real estate and mortgages to the mix. If done well, the results can beat more conventional portfolios while providing fewer jarring ups and downs.
For an example, let's take a look at what Vancouver-based Nicola Wealth Management is doing in its balanced income portfolio. This is the asset mix used by a majority of the firm's clientele of executives, business owners and professionals. Returns from Jan. 1, 2000, through June 30, 2011, averaged 6.7 per cent annually after fees, compared to 3.1 per cent for a traditional portfolio that is 60 per cent in stocks and 40 per cent in bonds. The traditional portfolio's returns were based on benchmark indexes for bonds and both Canadian and foreign stocks, and they weren't reduced by fees.
Here's how the balanced income portfolio is built:
Alternative strategies
Half of this category is accounted for by hedge funds, and the other half is made up of precious metals and private equity, which means shares in companies that are not listed on stock exchanges. The point of owning alternative strategy investments is to have assets in a portfolio that don't follow the ups and downs of the stock and bond markets.
Hedge funds are typically available for minimum investments ranging from $25,000 to $150,000. John Nicola, the chief executive officer at Nicola Wealth Management, highlighted the Vertex Fund and Sprott Hedge L.P. as two hedge funds used at his firm. Mind the volatility in these and other hedge funds, though. "What these guys are doing are making certain bets about the direction of things," Mr. Nicola said.
Canadian bonds
With interest rates as low as they are, Mr. Nicola has only a small position in Canadian bonds and is relying on other types of investments to generate income. "Right now, the way we look at bonds is that they're another form of cash."
Mr. Nicola is using a basic laddering strategy, which means dividing money evenly into bonds maturing in one through five years. As a bond matures, it's reinvested in a new five-year term. A mix of corporate and government bonds is used.
Mr. Nicola formerly used exchange-traded funds to get his bond market exposure because he likes the low fees. Just recently, he's been able to create what amounts to an in-house bond mutual fund for his firm's clients.
Canadian stocks
Mr. Nicola starts with a portfolio of dividend-paying stocks such as Rogers Communications, Tim Hortons and SNC-Lavalin Group and then uses covered call writing to increase the amount of income being generated. Covered call writing means selling, or writing, call options that allow other investors to buy your shares at a predetermined price. You're paid a premium for the options you write and that can enhance the income available from dividends alone.
"In our view we're in a secular bear market that, with the ongoing debt crisis, could go on for another five or even 10 years," Mr. Nicola said. "In markets like this, writing calls is a way of generating additional income with little risk of losing capital appreciation."
There's data to show that covered call writing outperforms in sideways and down markets, while lagging in a fast-rising market. Mr. Nicola's bear market view suggests there won't be much upside to sacrifice.
There are several ETFs that use a covered call strategy. (See my column of a few weeks ago here: tgam.ca/Cv9P
Cash
This weighting really just represents the cash holdings in the other investment categories listed here. If a client needs a standing cash component in his or her portfolio, Mr. Nicola may use a high-interest savings account from the likes of Ally or ING Direct.
Foreign bonds
This small position is covered off by using a global bond mutual fund, Templeton Global Bond. Mr. Nicola uses a low-fee O-class version of this fund, which is available to institutional investors. He buys a big position and then subdivides it into client portfolios.
Foreign stocks
"We're trying to get our clients to be more open about holding non-Canadian assets," Mr. Nicola said. He notes that Canadian investors are notorious for ignoring global markets, even though sectors such as health care and technology are thin in Canada.
Investments in U.S. and global markets have not yielded good results for many investors over the past decade. But Mr. Nicola said our high dollar makes it a good time to invest globally. "We're saying to our clients, you've got a dollar that has risen significantly relative to many major currencies around the world, which means you can buy foreign assets for better pricing than you've had for many, many years."
Mr. Nicola gets his foreign exposure by using four money management firms selected from among a large pool. Investors could replicate this by choosing a global equity fund.
High-yield bonds
High-yield bonds are issued by financially weak companies that have to offer extra high rates to attract investors. The conventional view is that high-yield bonds are much riskier than government bonds, but Mr. Nicola has a unique view on that.
"The risk of buying a 10-year government bond is infinitely greater than buying a pool of high-yield bonds," he said. " It's inflation. You're virtually guaranteeing a reduction of purchasing power if you lend money to the government at 2-per-cent."
As with foreign stocks and global bonds, Mr. Nicola gets his exposure to high-yield bonds by buying into funds offered by money management firms that also sell mutual funds (at higher cost).
Mortgages
Mr. Nicola uses private commercial mortgage pools for clients and he's generating yields of 4.8 per cent for first mortgages and 7.6 per cent for second mortgages. Compare those returns to bonds and guaranteed investment certificates and see why mortgages are a big part of the balanced income portfolio.
Retail investors can get exposure to mortgages through mortgage funds, although the fees undercut returns significantly.
Preferred shares
In a low interest rate world, preferred shares are an attractive option for generating income because the dividends they pay qualify for the dividend tax credit in non-registered accounts. Mr. Nicola looked at using exchange-traded funds tracking the Canadian preferred share market, but his firm ended up building its own preferred share fund. He likes the low fees of preferred share ETFs, but believes he's able to reduce risk by picking his own securities.
Real estate
Here's another asset that offers the potential of returns that aren't correlated to the stock markets. Retail investors can buy ETFs or mutual funds that hold real estate investment trusts. Mr. Nicola invests client money in real estate limited partnerships with properties in Canada and the United States.
Rob Carrick