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The Relevance of Alternative Investments in Volatile Markets

26 May 2020

The current economic and investment climate, brought on by the COVID-19 pandemic, has created considerable volatility and uncertainty in capital markets. The stay-at-home protocol that has become the norm in many of the largest countries around the globe has stymied these economies, leading to job losses and lost business as these economies have nearly ground to a complete halt.

In this climate, investors are struggling to make sense of the implications while trying to predict what may happen next, and determine what the short and medium term outlook will be for stocks and bonds. It’s in this economic climate that alternative investments can present a compelling path for investors seeking options and solutions in an environment devoid of a clear direction.

What Are Alternative Investments?

Alternative investments represent a relatively complex, non-traditional investment asset that resides outside the sphere of traditional publicly traded assets like stocks and bonds. Instead, alternatives are available on private markets, which can create challenges with how valuations are formed and evaluated for these assets.

Specialized assets like private equity, hedge funds, venture capital and financial derivatives are all considered to be alternative investments. As well, so-called hard assets like real estate, commodities (like precious metals), antiques, and high value collectibles, like rare wines, coins, and art, are also classified as alternatives.

Alternative investments differ from traditional stocks and bonds primarily because they are not traded on the same public markets. As a result, alternatives are not governed by the laws of supply and demand that impact the valuations and prices of traditional investment products.

This factor has significant implications for alternatives, particularly from a pricing and valuations perspective. There is an inherent “imperfect pricing model” when it comes to alternatives, which can add an additional level of opportunity (or risk) for investors. This in turn results in what is known as an “illiquidity premium” for alternatives.

Are These Assets Liquid?

As one might guess, this illiquidity premium is in part due to the fact these assets are only available on private markets. Alternatives are usually fairly illiquid investments, which means investors cannot always dispose of them readily for cash. Unlike traditional investments, the liquidity levels of alternative investments are rather low, but depend on many factors, especially asset type. For example, limited buyers for antiques create a less than perfect market condition, resulting in liquidity issues for sellers wishing to liquidate these assets.

Economic Valuation

As noted earlier, illiquidity premiums due to market inefficiencies can result in inaccurate pricing for these assets. Therefore, Valuing these assets can create both challenges and opportunities for investors wishing to partake in this market. Finding the true market value for assets in this category can add to the level of risk or create another layer of opportunity. But, creating opportunity by turning this negative into a positive takes a well seasoned investor, or investment advisor, with a keen eye and years of experience within the space.

The role of a trusted investment advisor in assessing the quality, risk profile and valuations of alternative investments cannot be understated. Advisors play an integral role in assessing these assets to ensure they are the right fit for your investment portfolio. This would include completing a thorough due diligence process when selecting the preferred investment options in this asset class.

Portfolio Diversification

Modern Portfolio Theory (MPT), developed by the economist Harry Markowitz in the 1950’s outlines the conditions and parameters by which an ideal portfolio can be constructed. Specifically, this theory identifies how an investor can maximize returns while also optimizing risk.

The key element in MPT is the concept of portfolio diversification – combining different assets in a given portfolio to mitigate risk while maximizing returns. MPT states that risk can be reduced through an effective portfolio diversification strategy, one that aims to reduce risk by investing in a basket of assets, each of which has its own unique and complementary risk profile for the portfolio.

Alternatives offer investors a unique opportunity with a risk profile that can often help offset the risks inherent to stock and bond assets. The low correlation between alternatives and publicly traded investments provides a compelling case to include these assets in a portfolio in order to enhance one’s diversification strategy.

Types of Alternative Investments

Real Estate

One of the most readily available and understood types of alternatives is real estate. Real estate assets are available for both residential or commercial properties, with most being secured by collateral against the property. As a result, real estate investments and their comparable mortgage investment counterparts represent lower-risk investment options in the alternatives space.

Hedge Funds

This type of asset is common with more sophisticated investors. Hedge funds typically require more significant investments compared to many other solutions. Hedge funds tend to be higher risk investments since many make use of derivatives and leverage in order to generate a higher return for investors. These funds aren’t usually available to most retail investors.

Venture Capital

Venture capitalists help startups and small to medium-sized businesses that they perceive to have above-average prospects for growth. More often than not, banks and other financial institutions are not interested in lending to these businesses due to the potential high risk that may be involved. Venture capital provides an investment alternative for those looking to profit from the growth and successes of new firms.

Private Equity

While often confused with venture capital due to their many similarities, private equity refers to those equities that are not available on public markets (like stocks and bonds). In the case of private equities, investors usually purchase shares in private companies or gain control of public companies with the intention of taking them private. Large institutional investors like pension funds and private equity firms dominate this landscape.

Currencies and Foreign Exchange

While it is a less common alternative investment option, currencies can indeed be classified as such since they aren’t correlated with the movements of assets in public markets. Access to these investments is somewhat limited for the average investor, and is limited to mutual funds denominated in a foreign currency, currency futures and to a lesser extent currency spot accounts. Currency has long been considered another element by which investment portfolios can be diversified to reduce risk and improve returns.

Alternative Investments and Market Volatility

It’s clear that by their very nature, alternative investments offer investors a unique opportunity to enhance portfolio diversification by reducing overall risk while at the same time improving returns.

In the current investment climate characterized by market volatility combined with uncertainty around the state of corporate profits and the economy as a whole, alternatives offer an attractive solution for clients seeking to generate appreciable returns.

The question then becomes which of the various alternatives available are best suited to the average investor and would thus make the most sense for their portfolios. It can be argued that real estate, and in particular Mortgage Investment Corporations (MICs) offer many investors a viable way to invest in alternatives.

The CMI MIC Family of Funds

The MIC fund currently offered by Canadian Mortgages Inc. (CMI) has consistently outperformed traditional investment markets over the last 5 years, delivering annualized yields of 8-9% (8.6% in 2019). With a minimum investment of only $5,000, CMI’s MIC fund offers investors an affordable way to access Canada’s property and mortgage market.

These funds are fully secured by real estate, with properties and borrowers thoroughly scrutinized through an extensive due diligence and qualification process through CMI’s team of highly experienced mortgage underwriters. This ensures only the best clients and mortgage assets are included in these funds.

Learn more about the CMI MIC family of funds and how they can be the right investment solution for you, or contact your investment advisor for more information.

The Relevance of Alternative Investments in Volatile Markets

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