What’s the right allocation to alternatives? It depends on the client

With more alternative investment options on the market, advisors are considering several factors when determining the appropriate allocation for clients in these often illiquid assets.

Alternative investments, such as private assets and hedging strategies, have been used on the institutional side for decades, but they’re becoming more accessible in the retail channel and being adopted by more advisors.

Vince Linsley, associate director of Toronto-based Investor Economics, an ISS Market Intelligence business, says alternative products are used primarily with high-net-worth clients. An Investor Economics report Mr. Linsley co-wrote says more than three-quarters of assets in alternatives in Canada were in client accounts greater than $1-million.

“It’s still, overall, small allocations but it has been growing,” he says.

Most advisors who use alternative investments target between 10 per cent and 30 per cent of a client’s portfolio in alternatives, the Investor Economics report says, although some look to hold as much at 60 per cent, following an institutional investing style.

The report says, “most dealers do not apply firm-wide recommendations with respect to allocations for alternatives, as individual client factors including liquidity needs, time horizons, and risk tolerance should form the basis of these decisions.”

The Big Six bank-owned brokerages and others have increased their use of alternative investments as several big asset managers, such as Blackstone Inc. and Brookfield Corp., have launched products aimed at retail investors. That’s made some investors more comfortable with the products, Mr. Linsley says. “These are firms we know we can trust.”

Some alternative investments aim to provide higher income or outperform public markets, while others offer diversification and a lack of correlation to the stock market, providing more stability and lower volatility.

“The true value of alternative investments is [they] deliver a portfolio that has lower volatility,” says Ethan Astaneh, wealth advisor and client relationship manager at Nicola Wealth Management Ltd. in Vancouver. “It gives investors this smooth return experience to be able to stick to a long-term strategy.”

The Investor Economics report found that only about half of advisors use alternative investments in client portfolios. The reasons cited for not using alts included liquidity constraints, their “high risk” label, and the difficulty explaining the products to clients, Mr. Linsley says.

As a result, liquid alternatives, which are available as mutual funds, are more popular as they overcome several of these hurdles compared with private investments such as private equity and private credit, he adds.

Theresa Shutt, chief investment officer at Harbourfront Wealth Management Inc. in Toronto, says the firm focuses on private assets. Harbourfront has three pools that invest in private debt, private equity and private real estate.

The pools’ managers do in-depth due diligence into the companies they invest in, Ms. Shutt says, and Harbourfront’s advisors are educated about private investments, which can be a challenge for many advisors, particularly solo practitioners.

Ms. Shutt says there’s no magic number for the allocation to alternatives in client portfolios; it depends on the investor, the size of their portfolio, their goals, age, liquidity needs, risk tolerance and knowledge of the alternative or private sector.

While the investments are suitable for many clients, Ms. Shutt says a client’s liquidity needs are key to determining if private alternatives are right for them. “If they’re older and need liquidity sooner, then privates are not appropriate,” she says.

Mr. Linsley agrees that liquidity is “a big hurdle for a lot of advisors” when it comes to alternative investments where there are restrictions on withdrawals or funds are locked up for some time.

Clients using alternatives need to be able to “weather a storm of liquidity,” Mr. Astaneh says. Not ensuring clients are suitable for alternatives from a liquidity perspective is the biggest mistake advisors can make, he adds.

Ms. Shutt argues for the benefits of private assets when it comes to diversification and the lack of correlation with public markets.

While there are about 3,000 public companies with annual revenue of US$100-million or more in the U.S., there are about 18,000 private companies that fit that description, Ms. Shutt notes.

“There tends to be less volatility,” she says. “There are more differentiated sources of alpha. So, it’s become very attractive – but it’s illiquid.”

Another concern for advisors is the sector is being promoted more heavily now and some may wonder if it’s “a lot of hype,” Mr. Linsley says.

Other challenges with alternative investments include the lack of transparency in performance and fees, which are often higher than for other investments. There are also often higher minimum investment requirements and the need for rigorous due diligence, the Investor Economics report notes.

Nevertheless, the asset class is poised to grow as more investors look for diversification.

“As asset management firms continue to deliver diverse products that maintain a prudent approach to portfolio construction, the focus on quality, transparency, and education will lead to further growth and adoption of alternatives in Canada,” the report states.

For more articles on alternative investments, visit Globe Advisor’s Alternative Investments section.