Ask most investors what they have in their portfolios and they’ll surely say stocks and bonds. While those assets are still the core building blocks of wealth, they’re no longer the only game in town. Over the past decade, a plethora of products has come to market to help boost returns and reduce risk.
For investors who care about diversification, incorporating other assets and strategies into a portfolio is a must, says Ted Rechtshaffen, chief executive officer of TriDelta Financial, a Toronto-based financial advisory firm. It’s what the best pension funds have been doing for years. “For the last 15 years, pension plans have been saying we need asset classes that provide higher yields and are less volatile than the stock market,” he says.
Most Canadians, though, only know about stocks, bonds, mutual funds and exchange-traded funds (ETFs). They’ve likely never heard of the securities and strategies that more sophisticated investors are using to diversify. Here are a few ideas to consider:
Strategizing with smart beta ETFs
Investors typically use index-replicating ETFs as a mutual fund replacement. They’re cheaper to hold than traditional funds, they can be bought and sold during trading hours as opposed to the end of the day, they outperform most active managers and they’re well diversified.
While investors continue to use these kinds of funds, many are now incorporating smart beta ETFs into their portfolios. These securities are designed to replicate, within an ETF structure, specific investment strategies, such as low-volatility, dividend and momentum investing.
Some, like momentum ETFs, are used to boost returns, while others, such as low-volatility, are designed to reduce market ups and downs. “Investors can now tilt towards value, growth, dividend-paying securities and so on,” says Michael Cooke, senior vice-president and head of exchange-traded funds at Toronto-based Mackenzie Financial Corp.
Every investor will incorporate smart beta differently, but some will use multiple strategies while others may employ just one. “If you feel a point in the market cycle where value stocks are undervalued, then you can now buy an ETF that expresses that view,” Cooke says.
Adopting active-management ETFs
Actively managed mutual funds have received a bad rap over the years, mostly because high fees make it difficult for them to beat their benchmarks. But proponents say there can still be a benefit to owning stock-picked securities. It can be helpful in emerging markets, says Cooke, where regional expertise is important.
Active management can also come in handy in the fixed-income sector, which is difficult for do-it-yourself investors to navigate, he says. If an investor wants higher-yielding corporate bonds, a manager would be able to choose those with the least risk for default, he says. Want to preserve capital? A manager can help choose the best government bonds.
While investors can get this expertise through mutual funds, actively managed ETFs are often cheaper and they can be traded during the day, like any ETF. They’re also more transparent than mutual funds, with investors being able to see exactly what the ETF holds versus only being able to view a fund’s top 10 or 20 holdings. “These things can resonate with investors,” Cooke says.
Understanding alternative investments
Pension funds have made alternative investments a major part of their portfolios. This can include commercial buildings, toll roads, airports and other hard assets, but it also encompasses hedge fund strategies. In either case, it’s about buying assets or employing strategies that have a low correlation to equity markets.
If stocks fall, alternatives should remain stable or rise. “Alternatives can ensure a portfolio is insulated against different outcomes,” Cooke says.
Just make sure you’re choosing a manager with a good track record. “There’s no magic formula,” Rechtshaffen says.
Picking private debt
Savvier investors have another diversification tool: private debt. These funds lend money to people – home buyers and business owners – who can’t get a loan from a bank, in part because many banks are now focusing more on lending to larger operations, forcing smaller borrowers to look elsewhere for funding. A portion of the interest paid gets distributed to the investor.
Rechtshaffen has been investing in private debt funds for nearly two years and says he’s so far made about 10 percent a year. It is riskier than buying fixed income, but returns are often uncorrelated to the stock market as people tend to pay back their loans no matter what the market is doing. “Not everyone will be comfortable with it, but I’ve been able to make money consistently,” he says.
Clearly, the market has evolved and investors can increase diversification by owning more than just stocks and bonds. With market volatility having risen this year, now could be the time to add some of these lesser-known securities and strategies to your portfolio. “You should be thinking about how to manage risk,” Cooke says. “You can’t forget that about inevitable ebb and flow of the investment cycle.
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