Beware of risky flyers

ARI SHIFF

I recently sat down with an investor who described real estate as an “addiction.” He said that even though he knew he should diversify his portfolio, he couldn’t say no to the prospect of investing in one more rental property with the possibility of a seven-to-eight percent return and a dependable cash flow.

As addictions go, an addiction to real estate has been a good one to have, at least in British Columbia. Our local market has moved steadily upward for two decades, and real estate well deserves its cherished place in any long-term investor’s portfolio. However, all up cycles inevitably end, as U.S. real estate investors learned, most recently in 2009. Given that Canada’s finance minister has loudly declared it his objective to cool the speculative trend in real estate across the country, investors should take note and be wary of overweighting their allocation to property right now.

Many of us have a core business or profession that we work hard at and know well. Whether doctor, lawyer or candlestick maker, we slowly build our businesses to the point where they start to throw off wealth that we can then use to invest in the future, both our own and our children’s. An easy way to think of this wealth portfolio is as a pie that has been cut into pieces. Our core business is often the biggest piece, real estate is frequently a sizeable piece and often insurance is another piece. Then comes the search for more pieces.

Adding pieces to the pie can reduce risk

By adding more pieces to the pie one can often lower risk, improve performance and improve the diversification of the whole portfolio. In fact, diversification is often called the only free lunch in investing because adding less-correlated sources of return costs nothing while adding the safety of multiple potential sources of profit. When the pieces fit together well, the size of the whole pie grows.

The typical next piece of the pie for many investors is the stock market because it is relatively easy to access and fairly liquid; a stock can be turned into cash with a call to a broker or the click of a mouse. Next stop is often bonds, which typically have lower returns than stocks, but better safety over time.

Stocks and bonds have their place, but both are subject to timing luck. It is not at all clear that this is the right time for either, especially bonds, which move inversely to interest rates. We have had rock bottom interest rates for years, as central bankers around the world have worked in concert to kickstart their economies. At current low rates, bonds do not deliver much of a return. Their value may actually erode if you own bonds as interest rates start moving back up.

Flyers are a growing danger

Flyers, typically defined as highly speculative investments, can start to look dangerously attractive in the current environment. These days, many investors target a seven-to-eight percent net return, which is strong enough to double an investment in 10 years. But a seven-to-eight percent return is not that easy to achieve in the current one-to-two percent interest rate environment. Flyers may appear to provide a promise of higher returns, but they likely also carry a much higher risk of loss of principal in today’s highly volatile and quickly inflecting economy.

There are, however, safer alternatives like infrastructure funds, private equity and funds of funds. These alternatives differ in important ways from real estate, stocks and bonds because they tend to continue to provide a source of return when those other asset classes do not. For decades, these alternatives have only been available to the super-rich, but that is changing. One of the side effects of the rise of the Internet has been an acceleration of the democratization of access to such investments. Today, even investors not fortunate enough to have a Goldman Sachs private banker on speed-dial can now access opportunities very similar to those offered by Goldman.

Alternative investments

Many local investment advisors are now recommending allocations to alternative investments. Subject to various securities rules and regulations, each of these can be accessed for as little as $100,000 to $150,000, which is bite-sized relative to the value of a typical house in Vancouver.

Such tactical allocations are a good way to dip a toe into what for many are unfamiliar alternatives. Some of these asset classes also offer tax advantages and the possibility of an annual cash flow, an important consideration for investors who require their assets to produce an income.

Each of these asset classes has its risks and benefits, and it is important to learn as much as possible about each and its performance history before committing. However, if we invest our money to grow it over time, the extra effort of investigating these alternative sources of return are worth the effort and should keep investors safely away from risky flyers.

Please note that alternative investments are complex and carry a risk of substantial losses. As such, they are not suitable for all investors. Past performance is not necessarily indicative of future results. Consult with your professional advisor before making any investment.

Ari Shiff is the founder and head of research of Inflection Management Inc., and the manager of the Inflection Strategic Opportunities Fund. He has more than 15 years experience in hedge funds and can be reached at [email protected] or at 604-730-9147.

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