How to build a millionaire’s portfolio
Friday, Aug. 8, 2014
One of the questions I get most often by investors is how they can benefit from alternative investing without having to make large, private, illiquid investments. Finding a true “liquid alts” portfolio can be as elusive as the Holy Grail or the City of Atlantis, but it is still worth attempting to construct one.
Here are the parameters of this exercise, along with some basic understandings. First, to be liquid, a security has to be either a mutual fund unit with daily liquidity or an exchange-traded instrument such as common stock or an exchange-traded fund (ETF). Additionally, one would hope that in the case of equities, there would be enough volume in the market to sell a $25,000 position in a day or two without affecting prices.
Second, the construction of the portfolio can also be part of its alternative nature. It can serve as an add-on to your current portfolio, but it could also viably replace your current portfolio.
Finally, because of the limitations regarding liquidity, investors must understand that, however alternative the makeup of their portfolio is, it may behave like a traditional portfolio of stocks and bonds when markets undergo significant stress because of its liquidity. Most of the time, however, investors will enjoy a total return largely divorced from the strong powers of broad equity markets and fixed-income securities that are driven by credit risk and interest rate risk.
Although any number of permutations exist, a fair characterization of a modern alternative portfolio adopted by the wealthiest investors (including bulk positions in illiquid instruments for which we will have to find a public proxy) is as follows: 15% income-producing real estate, 10% real estate debt (mortgages), 10% infrastructure, 20% private equity and private debt, 40% hedged exposure to stocks and bonds, and 5% cash and cash equivalents.
15% income-producing real estate. My guess is that you already have real estate investment trusts (REITs) in your portfolio. Because the long-term performance of individual REITs is rarely better than the REIT index, this entire 15% can be allocated to the iShares S&P/TSX Capped REIT Index ETF (XRE/TSX).
10% mortgages. There are a number of publicly traded mortgage funds that specialize in the origination and administration of mortgages in the construction and development industry. The sector has become relatively crowded in the past couple of years, but there are very competent firms active in the space. A few even trade at discounts to their net asset value. Candidates for this allocation include mortgage pools from Timbercreek Asset Management Inc. (MTG/TSX), Trez Capital Mortgage Investment Corp. (TZS/TSX), Atrium Mortgage Investment Corp. (AI/TS) and Firm Capital Mortgage Investment Corp. (FC/TSX).
10% infrastructure. This area can be difficult because many firms that are active in the infrastructure/renewables space are huge conglomerates that also run many other businesses. On a global scale, one might consider the BMO Global Infrastructure Index ETF (ZGI/TSX). A Canadian option could be the Dream Hard Asset Alternative Trust (DRA.UN/TSX), whose mandate includes shifting mortgage assets into tax-efficient renewable infrastructure yield over time
(conflict note: I sit on the board of this trust).
20% private equity and private debt. The world’s largest institutional investors, including Canada Pension Plan and Ontario Teachers’ Pension Plan, invest heavily in private equity as a way to extract higher risk-adjusted returns over time. Ironically, the only way for investors to gain liquid access to this return stream is to buy into a publicly traded private-equity manager.
In Canada, Onex Corp. (OCX.TSX), having been a major player in private equity for more than 30 years, is an obvious choice. If you would like to take advantage of the enormous opportunity available in the small business space as baby boomer entrepreneurs sell their businesses, check out Mosaic Capital Corp. (M/TSX-V and M-PA/TSX-V), which offers both equity and income-like vehicles.
In the U.S. behemoth private-equity firms that are publicly traded include KKR & Co. LP (KKR/NYSE) and the Blackstone Group LP (BX/NYSE).
40% hedged stocks and bonds. If you are a do-it-yourself investor, the tools to gain access to virtually any market in the world are available cheaply and in a liquid fashion using simple ETFs. In addition to the long-only broad index replicators most ETF manufacturers offer, there are also many actively managed ETFs that provide internal risk management through mechanisms such as duration management in bond portfolios or defensive options overlays on equity portfolios.
A good example of these products is the actively managed group of ETFs offered by Horizons ETFs Management (Canada) Inc. These ETFs give investors the ability to simultaneously isolate and manage risk at much lower costs than many mutual funds. In the fixed-income space, for example, the Horizons Active Yield Matched Duration ETF (HAF/TSX) actively manages duration along with credit risk.
For equity investors, Purpose Investments Inc. offers the Tactical Hedged Equity Fund (PHE/TSX), an ETF designed to provide broad exposure to the U.S. equity market that modifies its exposure to equities between 25% and 75% over time depending on market conditions. This ETF is designed to provide investors with most of the upside of the equity markets with significantly reduced losses when the markets fall.
5% cash and cash equivalents: In a low interest rate environment, holding cash can be painful, since the return on that cash is low, fully taxable and will hardly keep up with inflation. If the amounts are low, keeping it in a “high interest” savings account at a bank may be your best bet. For larger amounts, consider ETFs that replicate money market returns. Either way, you’re looking at 1.25% or less on your cash in the current environment. You will, however, have cash at the ready for emergency purposes or to buy securities when they become cheap.
This portfolio will not immunize you from market volatility, and will provide only some of the benefits enjoyed by the world’s institutional investors. Applied with rigor, however, it may vastly improve the risk-adjusted returns of your portfolio over time.
David Kaufman is president of Westcourt Capital Corp. a portfolio manager specializing in traditional and alternative asset classes and investment strategies. He can be contacted at firstname.lastname@example.org .