Alternative Investments: A Strategic Portfolio Inclusion
Grant Alexander Wilson, Ph.D.
Department of Management and Marketing
Edwards School of Business
University of Saskatchewan
Dr. Wilson is a faculty member in the Department of Management and Marketing at the Edwards School of Business, University of Saskatchewan. He teaches strategic management, entrepreneurship, and technology commercialization courses. His current research interests include entrepreneurship, management strategy, innovation, and organizational learning. Dr. Wilson has published in the Journal of Small Business Management, Journal of Small Business & Entrepreneurship, Journal of High Technology Management Research, Journal of Innovation Management, Strategy & Leadership, and other esteemed academic journals.
According to the Bank of Montreal (2020), 77% of Canadians have investments. Of these investments, Canadians are “nearly split when it comes to investing their savings (53%) or keeping them as cash (47%)” (Bank of Montreal, 2020). The data further suggests that most of these positions are in conventional investments. Conventional investment “categories include stocks, bonds, and cash” (Chen, 2021). Paraphrasing Rose (2019), the average investor believes that the key to personal wealth is throwing money into the stock or bond market. In contrast, a study by Fidelity Investments found that wealthy individuals were likely to accumulate it through real estate investments (Sightings, 2018). Alternative investments such as real estate are “all the rage as advisors and clients search for fresh income” during the COVID-19 pandemic (Burton, 2020). Currently, the conventional portfolio is no longer adequate, as fixed-income investments (e.g. bonds) are offering nominal returns and equity markets (e.g. stocks) are more volatile due to market uncertainty (Bank of Canada, 2021; Yahoo Finance, 2021a). As such, participation in alternative investments is growing among savvy investors (Burton, 2020).
Alternative investments do not fall into conventional investment categories (e.g. stocks, bonds, or cash). Examples of alternative investments include private equity, hedge funds, managed futures, commodities, derivative contracts, and real estate (Chen, 2021). Traditionally, mostly accredited or institutional investors hold alternative investments (Chen, 2021). In Canada, an accredited investor is defined most commonly as an individual that has net assets of more than $5,000,000 or earns over $200,000 per year (The Ontario Securities Commission, 2009). “An institutional investor is a company or organization that invests money on behalf of other people” (Chen, 2020). According to Chen (2020), collectively, institutional investors are the “largest force behind supply and demand in securities markets.” Due to their size, institutional investors have opportunities not typically available to retail investors. “A retail investor is an individual or non-professional investor who buys and sells securities through brokerage firms or savings accounts” (Palmer, 2019). Today, accredited and institutional investors are actively participating in alternative investments due to their advantages over conventional investments and increasing accessibility. Specifically, alternative investments are becoming more feasible for retail investors via real estate investment trusts (REITs) and other securitized assets.
ADVANTAGES OF ALTERNATIVE INVESTMENTS
Alternative investments have numerous advantages over conventional investments. These advantages include counterweight to conventional assets, portfolio diversification, and inflation hedge. A counterweight investment is one that often responds inversely to another investment. For example, when stocks fall, bond prices often rise (Leonhardt, 2019). As such, alternative investments can act as counterweights to conventional investments, reducing the overall risk profile of an investment portfolio. Similar to counterweight investments, diversification reduces risk. “Diversification is a risk management strategy that mixes a wide variety of investments within a portfolio. A diversified portfolio contains a mix of distinct asset types and investment vehicles in an attempt at limiting exposure to any single asset or risk” (Segal, 2021). Due to the loss of purchasing power resulting from inflation, Milton Freidman describes it as “taxation without legislation” (Shaw, 2009). Accordingly, prudent investors have explored ways to hedge against inflation. “An inflation hedge involves investment in an asset that is expected to maintain or appreciate in an inflationary period” (Wilson, 2021). Historically, alternative investments such as Canadian residential real estate and farmland have served as inflationary hedges (Wilson, 2021). The greatest benefit of alternative investments is the potential return. Despite the articulated benefits, alternative investments have drawbacks.
DISADVANTAGES OF ALTERNATIVE INVESTMENTS
Shortcomings of alternative investments include valuation complexity, low liquidity, lack of regulation, and riskiness (Chen, 2021). Alternative investments are often difficult to value due to their non-public nature. Data collection and analysis are therefore problematic, as market prices are not widely available and the uniqueness of certain asset classes lack adequate comparables. A typically argued disadvantage of alternative investments is low liquidity (Chen, 2021). As compared to equities, most alternative investments are more difficult to sell. However, this argument is susceptible to a strong counterargument. The liquidity of any asset is dependent on the participation of buyers and sellers. Therefore, equities that are depreciating or not actively traded do not have such liquidity benefits, raising concerns related to the argument’s generalizability over alternative investments. “Alternative investments are often subject to a less clear legal structure than conventional investments” (Chen, 2021). In Canada, alternative investments themselves are not typically required to be licensed, authorized, or regulated (The Legal 500, 2021). Therefore, due diligence is paramount when participating in alternative investing. As with other investments, higher returns are most often accompanied by higher risks. However, this trait is not universal, as many alternative investments are more volatile than a conventional investment in the stock market.
CONVENTIONAL VERSUS ALTERNATIVE INVESTMENTS
To compare the historical performance of conventional and alternative investments in Canada, a series of analyses were performed utilizing publicly available data from some of the most common asset categories. Conventional investments included Canadian stocks, bonds, and interest on cash deposits. The Toronto Stock Exchange (TSX) is Canada’s primary stock exchange. Accordingly, the TSX Composite index was used to assess stock market performance. As the 10-year bond it is the most common fixed-income asset in Canada, it was used to assess the bond market. Canada’s cash deposit interest rate was used to evaluate cash market positions. Since alternative investments vary and publicly available information is limited, Canadian residential real estate, farmland, and commodities were selected for investigation. Canadian real estate was assessed by residential and agricultural properties. Canadian residential real estate was based on changes to existing home values and new home values. Farmland values were used to assess agricultural real estate performance. The performance of the commodity market performance was assessed based on the Bank of Canada’s (2021b) commodity price index (BCPI) because it includes 26 of the most important commodities produced in Canada and sold globally.
The 10-year appreciation of Canadian residential real estate supports Chen’s (2021) argument that alternative investments may generate stronger returns. Exploring changes to new and existing home values showed consistent annual appreciations totaling 21.50% and 11.18%, respectively (Statistics Canada, 2021; Global Property Guide, 2021) (Figure 1).
The appreciation of farmland was even more significant than residential real estate, as the average annual increase was 10.86% with a total appreciation of 119.50% (Farm Credit Canada, 2019; Farm Credit Canada, 2020) (Figure 2).
While Canadian alternative investments including residential and agricultural real estate markets showed consistent appreciations from 2010 to 2020, the same cannot be said for commodities. The BCPI’s 10-year average value change was -0.59% per year, totaling -6.53% (Bank of Canada, 2021b). Moreover, the examination of the annual changes to the commodity market relative to new home values and farmland explicates its volatility (Bank of Canada, 2021b) (Figure 3). Annual BCPI changes were extremely inconsistent ranging from gains of 21.37% to losses of 36.15%. Based on these comparisons in this timeframe, it can be concluded that Canadian real estate is advantaged over the commodities market. Furthermore, among the Canadian real estate investments analyzed, farmland investments were superior to residential real estate investments based on the 10-year appreciation.
Using new home values and farmland as comparables, they were analyzed with interest on cash deposits as well as 10-year bond yields and the TSX. Deposit interest in Canada fluctuated only moderately, averaging 1.00% from 2010 to 2020 (Trading Economics, 2021). Similar to cash deposits, 10-year Canadian Government bonds are characterized by low returns. From 2010 to 2020, with the exception of 2018, yields of newly issued bonds have consistently declined (Bank of Canada, 2021a). Unlike interest on cash deposits and the bond market, the TSX has shown annual gains of as much as 19.14% (Yahoo Finance, 2021a). A comparison of annual changes to new home values, land values, bond yields, and the TSX shows that real estate offers consistent appreciation and low volatility (Figure 4). Although annual appreciations of the TSX rival farmland values and exceed new home values, annual depreciation of similar magnitude are not uncommon. While the 10-year Canadian Government bond offers consistency, new bond values are low and continue to decline. It is apparent that in the Canadian context, positions in alternative investments such as real estate are more favorable than the considered conventional investments.
Inferences based on this investigation are not without limitations, as the analysis was performed with select Canadian investments. However, broadening the investigative context to include similar U.S. assets produced congruent results.
In addition to the previously analyzed Canadian assets, the New York Stock Exchange (Stock Market B), 10-year U.S. Government bond (Bond B), and S&P Goldman Sachs Commodity Index (Commodity Market B) were included in a reward and risk analysis (Table 1). Reward was measured using the 10-year average annual change of the asset value and risk was the standard deviation of the mean score. Standard deviation is the amount of variance among a set of values. If the values are “further from the mean there is a higher deviation within the data set” and there is greater variance (Hargrave, 2021). Therefore, risk was assessed based on the standard deviation of the asset value change. The reward and risk comparison showed that alternative investments in real estate had moderate to high rewards and low to moderate risks. In contrast, the stock markets presented high rewards and high risks. Inversely, the bond market showed low rewards and low risks. Although the commodity markets differed, both presented high risks. Although the data set was expanded to include U.S. assets, it is recognized that the analysis remains limited in scope. However, it was apparent that alternative investments such as real estate had benefits over conventional assets.
Today, investors are finding that conventional investment categories such as stocks and bonds are simply not adequate to preserve or generate wealth. As the global pandemic endures, there is an acute awareness of the benefits related to alternative investments among savvy investors. And rightfully so, as the analysis of select Canadian and U.S. conventional and alternative investments showed that residential and agricultural real estate balanced potentially appealing rewards with potentially lower risk. As stock and bond markets present extreme volatility, Warren Buffett’s first rule to “never lose money” and second rule to “never forget rule number one” are proving more difficult. Simply, investors need to have a clear strategy to include alternative investments in their portfolio for growth and risk management purposes (Pricewaterhouse Coopers, 2018).
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