How I learned to stop worrying and love alternatives

The old way of thinking will not work in the future, so it is imperative that investors, advisers and ETF providers rethink how they construct their portfolios and manage risk. It is my belief that alternatives – a misunderstood bucket of different asset classes ranging from real estate to commodities to hedged strategies – will be a large part of the changing face of risk management.  

Maybe where we need to start is by changing how we discuss and describe alternatives. Since the late 1990s it has become popular to segment portfolios according to the “Yale Model,” which split the endowment’s asset classes into equities, bonds and also separate categories called hedge funds and alternatives – including private equity, venture capital, real estate and other private assets. This approach incorrectly classified alternatives and hedge funds as new asset classes, hoping to help build better diversification in portfolios.  However, this is incorrect because often they are based on the same risk factors as equities and bonds in general and so diversification is in fact not increased, but sometimes decreased.  

What I believe is that we need to start thinking in terms of “intra-asset class” risk management. By that I mean instead of just trying to find different asset classes to offset risk, we need to integrate risk management within each of the traditional asset categories. How do we construct the equity component of a portfolio so that it receives equity-like returns at a lower risk level? How about bonds, real estate, commodities and so on? 

The solution to this is to look at different risk management strategies within each of these categories. For example, within the equity component of an investor’s portfolio we have to look beyond a simple long-only approach to, for instance, a tactical hedged equity strategy that aims to provide the same rate of return with less volatility and lower risk of major loss by hedging part of the portfolio’s market risk exposure.  

Using innovative strategies will be especially important for the bond component of an investor’s portfolio. A passive approach to fixed income is no longer a realistic approach unless the investor is willing to take a lower return (read: 2% vs 8%). Alternative strategies that involve active management, tactical rebalancing and/or the use of derivatives to manage interest rate exposure and duration risk will need to become far more commonplace should investors want to achieve and maintain the returns to which they’ve become accustomed.

In the end, I believe that Canadians, advisers and fund managers will become more comfortable utilizing non-traditional asset classes and investment strategies, bringing what may be considered different into the mainstream. Maybe, in time, Canadians will even learn to love alternatives.