In today’s diverse investment landscape, alternative assets have become an essential tool for advisors looking to meet their clients’ evolving financial needs. By providing additional ways to diversify portfolios, manage risk, and increase potential returns, alternative investments can significantly enhance an investment strategy. Here’s everything you need to know about integrating alternative investments into your clients’ portfolios.

Key Takeaways:

• Alternative investments refer to any assets that don’t fall into the traditional categories of stocks, bonds, or cash.
• These investments offer unique risk-return profiles, help diversify portfolios, and can even provide tax benefits.
• Mortgage Investment Corporations (MICs), as a part of alternative investments, provide stable income opportunities and can be held in tax-advantaged accounts like RRSPs and TFSAs.

What Are Alternative Investments?

Alternative investments are assets that differ from traditional investment vehicles like stocks and bonds. They include categories such as private equity, private credit, real estate, and hedge funds. For years, these investments were primarily accessible to institutional investors. However, changes in regulation and asset management practices have allowed retail investors to tap into this lucrative market.

Alternatives have moved from a small portion of investment portfolios to a core asset class for many investors. For example, global pension funds had only 5% of their portfolios in alternatives in 1996, but by 2019, this number grew to 26%. In Canada, investors are even more inclined to increase their allocations to alternatives. The Canadian Pension Plan Investment Board (CPPIB) has around 60% of its portfolio invested in private equity, infrastructure, real estate, and credit.

Why Consider Alternative Investments?

Advisors constantly strive to help clients reach their financial goals, and alternative investments can play a critical role. Here are five key reasons to integrate alternatives into a portfolio:

1. Unique Risk-Return Profile
   Alternatives like hedge funds, private equity, and real estate offer a different risk-return relationship compared to traditional stocks and bonds. When markets experience volatility, alternative investments may offer stability or even positive returns. This diversification can improve long-term returns.
2. Diversification
   Alternative investments add diversification to a portfolio by lowering correlation with traditional asset classes. While mutual funds and stocks can be impacted by market fluctuations, alternatives help smooth out volatility, especially during market downturns.
3. Capital Growth Potential
   Alternatives, such as private equity and real estate, often have low correlation to the equity and bond markets, providing unique opportunities for capital growth. These investments can unlock returns not readily available through traditional markets.
4. Consistent Income
   Certain alternative assets like real estate and private credit can provide reliable income streams. For instance, Mortgage Investment Corporations (MICs) offer monthly dividends, which investors can reinvest for compounded growth.
5. Tax Benefits
   Many alternative investments come with tax advantages. Real estate investments, for example, allow you to claim depreciation under the Capital Cost Allowance (CCA), which can offset rental income and reduce taxable income. Additionally, alternatives can often be held in tax-sheltered accounts like TFSAs and RRSPs, which maximizes your clients’ savings.

Types of Alternative Investments

There are several types of alternative investments in Canada, each with distinct characteristics. Let’s break down some of the most popular options:

• Private Equity: This involves investing in private companies not listed on the stock market. Private equity funds typically acquire stakes in companies, aiming to improve their value before selling them for a profit. These investments can yield above-average returns but may involve lower liquidity.
• Private Credit: This refers to non-bank loans provided to businesses that don’t meet traditional lending criteria. By investing in private credit, you can gain exposure to higher-yield debt markets, with the potential for attractive returns.
• Hedge Funds: Hedge funds employ a variety of investment strategies to generate returns. These strategies might include long/short positions, market-neutral approaches, or even global macro strategies. While they can be complex, hedge funds offer opportunities to earn higher returns, especially during volatile periods.
• Digital Assets: Digital assets like cryptocurrencies and NFTs represent a new wave of investment options. While these assets provide the potential for substantial returns, they also come with high volatility and a lack of regulatory protections compared to traditional investments.
• Real Estate: Real estate is one of the largest asset classes globally, valued at over $600 billion. Investors can access real estate through direct ownership or through Real Estate Investment Trusts (REITs) and Mortgage Investment Corporations (MICs). These options provide a way to benefit from the real estate sector without directly managing properties.
  • REITs: These funds pool investors’ money to invest in income-generating real estate, providing dividends to investors without requiring direct property management.
  • MICs: These funds focus on mortgages and distribute income derived from mortgage payments. Unlike REITs, MICs don’t involve property ownership but still offer steady income streams.

How Much Should You Allocate to Alternative Investments?

The appropriate allocation to alternative investments depends on your client’s overall financial goals and risk tolerance. Experts suggest that allocating 10% to 20% of a portfolio to alternatives can help achieve diversification and potential returns. In Canada, real estate continues to be the most popular alternative asset class, though private equity and credit are also gaining traction.

Conclusion

As an advisor, understanding the variety and benefits of alternative investments allows you to build more diversified and resilient portfolios for your clients. With the right mix, alternative assets can complement traditional investments, offering unique growth potential, steady income, and valuable tax advantages. Whether you choose real estate, private equity, or mortgage funds like MICs, there are numerous opportunities to enhance your clients’ financial futures.