How we use alternative investments in order to build resilient portfolios.
At Anchor Pacific, we were early adopters of establishing robust frameworks for the evaluation, inclusion and implementation of alternative investments within multi-asset investment programs.
Join Mark and Steve for a candid conversation about alternative investments, including our philosophy and underlying belief systems with respect to managing investment portfolios and optimizing client outcomes.
Anchor Pacific is set up to function as a Chief Investment Office providing specialized and customized discretionary and advised services for families, financial advisors, allocators and asset owners with respect to portfolio construction, risk analytics and manager/strategy selection.
I’m here today with our founder Steve Adang to discuss how we design and manage investment portfolios. Today we’re specifically going to discuss the use of alternative investments.
Do we invest in alternatives?
Yes, we use alternatives quite extensively. Our multi-asset portfolios run anywhere from 40-60% passive with most of our equity exposure being indexed. The majority of our allocation to actively managed strategies would likely be deemed alternative.
What types of alternative investments do we use?
We consider the full global opportunity set across the dimensions of both liquid and illiquid, as well as public and private. We view something as an alternative by what the manager does and how they do it as opposed to what the label may say it is. But generally speaking, it's either an asset class outside the traditional definitions of public equity and fixed income or the non-conventional implementation of these asset classes through some type of edge, skill, or structure based-investing strategies. Our focus is generally on the latter as a thoughtfully constructed portfolio of complementary strategies has the ability to create a really interesting risk profile with a compelling return that is truly independent of the traditional market risk factors, mainly equity, credit and interest rate risk.
Are you referring to liquid alternatives?
Not exactly. Liquid alternatives are a marketing initiative driven mainly by the asset management industry to make alternative investments more accessible to the masses, a democratization of the asset class. Regulators in the US, Europe and Canada most recently have adopted standards allowing for access to offerings issued via prospectus which usually comes with smaller minimum size and daily or weekly liquidity which is appealing to retail investors. What’s important to understand is that properly represented retail investors have always had access to alternatives through advisors that are fully licensed and operating as fiduciaries. We refer to the strategies I referenced earlier as marketable alternatives as opposed to liquid alternatives.
Could you explain what you mean by ‘marketable alternatives’?
Marketable alternatives clearly delineate between the use of public and private securities and the liquidity of the actual structure that is being invested in. The label refers for the most part to strategies involving publicly traded investments within a structure that is sufficiently liquid – typically monthly or quarterly with some degree of advance notice, so for instance quarterly liquidity with 45 days notice. The vehicles are typically open-end in nature offering a more continuous opportunity to invest and redeem which matches well with the liquidity of the underlying securities in the strategies. At the opposite end of the spectrum would be the category of private investments which are typically offered through a long-dated commingled fund which is locked up from returning capital until the investments are liquidated typically longer than 5 years and in many cases up to 15 or 20 years – examples of this would be investments in private companies (traditionally Private Equity), private growth companies (Venture), and certain infrastructure and real estate projects. So we tend to separate marketable and illiquid and we tend to specialize within the marketable segment.
How are we using alternatives specifically?
Alternatives are typically thought of as being return additive, risk-reducing, or risk diversifying. Most marketable strategies are more risk diversifying while private illiquid investments are seeking excess return. We use marketable alternatives to create an independent and unique return stream that hedges against the rich valuations in equities and fixed income – we’re seeking to earn a significant premium over inflation with a risk profile that resembles more that of a typical modestly aggressive fixed income allocation.
It’s extremely important to understand that investment within alternatives needs to be done programmatically.
It means that alternatives however you define them need to be looked at within the context of an entire portfolio. It starts with defining your objectives for your alternative allocation and then figuring out how you are going to execute. The problem is that the industry marketing machine is incredibly intense here – there is a proliferation of products out there with the same pitch which is generally naïve and incomplete bordering on misleading. Just because sophisticated institutional investors use alternative investments extensively doesn’t necessarily mean that they belong in every investor’s portfolio. This is not a technique and execution risk is high due to the combination of complexity as well as high cost. You see this in the dispersion of performance of major university endowment portfolios – most of this dispersion is likely the result of execution suggesting that improper implementation and/or poor execution has a high probability of having a negative effect on portfolio performance.
What is an investor to do here?
It comes down to alignment and capable representation. Most importantly that a fiduciary is responsible for these decisions and can filter out all of these products to find the most viable building blocks. The gatekeepers and stewards are few and far between. We act as a gatekeeper for the investor and all of these offers and distractions are 99% noise. Having the right frameworks, process and infrastructure in place is critical – it allows for the casting of an extremely wide net yet having the flexibility of a robust and efficient analytical process to choose a discrete small number of strategies and exposures that function collectively well across a wide range of market and economic scenarios.
What about private investments?
Privates are not our principal area of focus. While we see a great number of opportunities, our participation is quite low. Most clients have an allocation of 5-15%. We own a diversified portfolio of private stable income-producing US real estate, mainly multi-family apartments and industrial in areas experiencing population migration, through an open-end fund managed by one of the industry’s best capital allocators. Additionally, we own a portfolio of Canadian farmland for exposure to land, water and the theme of global food scarcity. There is also a strong ESG component to this type of holding. These are both low-risk allocations to real assets which tend to positively correlate with inflation and are managed by highly specialized seasoned well-capitalized asset management firms. We haven’t ventured significantly beyond as access to some of the more interesting exposures becomes particularly limited especially if the overall portfolio size is on the smaller side. There is excess return here to be captured here but it's pretty much a closed game due to size and resource constraints as well as governance issues.
What is the governance issue?
It’s relatively simple. Institutional investors, even smaller ones such as Foundations, Endowments, and other non-profits generally have governing principles with respect to the use of the funds earmarked for investment. The entities have formal budgets and typically an investment committee that reports to a Board. All of this enables there to be a clear outlining of goals and thus a proper allocation to truly illiquid assets that will remain in place. You may still be limited by size here but the governance constraint is removed and a dedicated allocation to illiquid investments can be properly structured into an overall investment program. An individual family or even a large family enterprise rarely employs this type of governance set up with the exception of the super large single-family offices that may have some form of family constitution in place. Without this formalized governance in place, it is very difficult to set an appropriate allocation for illiquid investments because we have seen many times where the initial client discovery suggests a time horizon well in excess of ten or even twenty years and circumstances change with substantial raiding of the principal for various unforeseen needs and passion projects. This ultimately causes distortion in not only the prescribed asset allocation targets but is likely to result in risk for failure with respect to one’s intended goals for protecting and compounding their wealth capital.
What about private debt specifically?
We’ve done very little to date. We have a single exposure specifically to a program that provides ultra-short highly secured loans to private businesses on mission-critical assets such as working capital and various forms of account receivables. It’s not terribly exciting – we expect to earn returns about 3-3.5% above the expected return on investment-grade bonds, around 5.5-6%, and the exposure serves as a partial fixed income replacement. The liquidity is appropriate given the revolving nature of the loans, security and first priority of claim. We sleep well at night knowing that the program is managed by individuals with an institutional pedigree and that the requisite operational safeguards are in place.
That's it? No other private debt?
No. Not from a direct origination and servicing perspective.
Frankly, the risk-reward just isn’t there – meaning the potential excess returns are fraught with far too many risks and uncertainties than we are comfortable with. There is a significant issue with adverse selection, conflicts of interest, and the principal-agent problem. This is mainly with structures that have been built here in Canada for retail. We do see some potential in more resilient structures once you leave Canada and enter more into the institutionally targeted marketplace.