Alternatives: Risk Premia in Inflationary Times

Winds of Change

A portfolio consisting of 60% stocks and 40% bonds is so common amongst investment management practitioners that it’s often called, without question, the ​“60−40 Portfolio”. In theory, the larger slice of equity exposure delivers growth and inflation protection, while the smaller fixed income component provides capital protection during times of market volatility. For years, investors, from retirees to the largest pension funds, have successfully deployed the tried-and-true model to maximize long-term returns and minimize volatility — but many believe those days are now over. 

We’re in a different market environment today, experiencing conditions not seen for more than a generation. While some risk factors have been normalized over several years, such as persistently low interest rates and lower forecasted equity returns, higher inflation is a new variable that will test the mettle of many investment managers. 

For example, on March 10^th, U.S. consumer inflation jumped to 7.9% year-to-date — the sharpest spike since 1982,¹ and potentially a harbinger of higher prices to come. Similar, if less dramatic, were the price increases also being reported in Canada. Now is the moment to question the conventional wisdom of traditional portfolio construction, and to look for alternative solutions that will add inflation protection to the 60% equity weight in your portfolio. Done correctly, this should help optimize risk-return trade-offs and provide the necessary tools to manage inflation.

“It is not the answer that enlightens, but the question.”

The Case for Including Alternatives

As the French-Romanian playwright Eugene Ionesco once noted, ​“It is not the answer that enlightens, but the question.” This suggests just the act of questioning can be illuminating. 

So, from an investment perspective, ICPMs and family offices should ask if it’s worth exploring the use of Alternative investments to improve a 60-40 portfolio? Many of Canada’s leading public sector defined pension plans have already bought into the idea that alternatives will play a major role in future allocations. In fact, according to the Bank of Canada, ​“64% of (pension) plans in our sample shifted away from the traditional 60/40 mix” in favour of ​“portfolios with more alternative assets, such as private equity, real estate and infrastructure.”² The BoC analysts underline this point with the observation that, ​“For one-third of these plans, the portfolio overhaul is substantial — representing more than 30% of all assets.” Conclusion: Yes, alternative investments can provide additional risk premia, diversification (low correlation to public markets), and in most cases, a critical inflation hedge. 

A second, but no less important question is, how can investment counsellors and family offices access alternative investments given that many are expensive and difficult to trade? Not all investors can match the scale and depth of expertise of large pension funds. Those pensions have the first pick of investment opportunities, and are also direct investors in real assets, meaning they don’t face the capacity constraints, placement delays and illiquidity risks associated with Pooled exposures. ICPMs and family offices may lack those advantages, but the appeal of alternative investments is the same for them. So, how can non-pension fund investors gain access to alternatives? The most efficient route, we believe, is through Exchange Traded Funds (ETFs).

ETFs: A Compelling Solution for Alternatives

When allocating to alternative assets, many will choose a third-party manager. However, ETFs provide access to the same risk premia and diversification benefits without any of the negatives associated with an external fund manager. For example, ETFs are:

• Less expensive than most third-party managers 
• Scalable and liquid, allowing new units to be added or redeemed per changes in demand (third-party solutions are, by contrast, often closed to new subscriptions) 
• Transparent and traded on a public exchange, with a verifiable data set to model risk assumptions
• Always fully invested, there’s never a gap between when an investment is committed and placed 

The range of ETFs is also growing, providing investors with many different options to access alternative investments without the high cost, liquidity and capacity risks associated with direct investing. Indeed, there are ETF proxies for each of the main categories of alternative investing: real assets, private equity, commodities/​precious metals, and private debt.

Real Assets

If you’re interested in real assets, then GRNI and TOWR offer exposure to the infrastructure that supports megatrends like decarbonization and data consumption. Both ETFs are high conviction, actively managed portfolios of 20 to 40 publicly listed securities selected by Brookfield Public Securities Group, an established front-runner in both areas.³

GRNI - BMO Brookfield Global Renewables Infrastructure Fund – ETF Series: Invests in the listed securities of global renewables and sustainable infrastructure companies that provide consistent, non-cyclical income along with a hedge to inflation. Infrastructure-like companies typically have a lower beta and a lower correlation to broad public markets.

• Exposure is aligned with the growing transition to net-zero economy
• Invests in the physical infrastructure behind renewable power, such as grid modernization, offshore wind and water sustainability
• Benefits from governments’ $100 trillion global decarbonization commitments⁴

TOWR - BMO Brookfield Global Real Estate Tech Fund – ETF Series: Invests in global real estate companies focused on new economy sectors that will benefit from a rise in data consumption and technology disruption. This includes data centres, communications towers and logistics facilities — all of which differs dramatically from traditional real estate holdings, such as office and shopping mall REITs. Real estate assets typically pay steady income with capitalization rates that are correlated with economic growth, as opposed to financial assets such as stocks and bonds. 

• Tech-focused real estate usually generates income with low sensitivity to inflation and economic cycles
• Capitalizes on the increased demand for ecommerce, 5G transition, data storage and other communications infrastructure

Private Equity

If you’re looking for a private equity exposure, ZINN invests in listed securities that offer exposure to disruptive technologies on the radar of every late-stage venture capitalist. ZINN – BMO MSCI Innovation Index ETF: Developed in conjunction with ARK Invest and MSCI, this ETF targets companies engaging in disruptive innovation themes like autonomous technology, genomics, fintech and next generation internet. ARK defines the search criteria for structural megatrends, while MSCI builds the investable universe to ensure optimal diversification. Over the long term, the ETF is designed to capture similar sources of growth to private equity, which can help insulate capital from inflationary pressures.

Precious Metals

We offer two ETFs that are excellent proxies for precious metals securities: ZGD and ZJG. These ETFs provide access to senior and junior gold producers, respectively, and both act as an inflation hedge while protecting against macro economic risks, geopolitical tensions and a weak U.S. dollar.

ZGD - BMO Equal Weight Global Gold Index ETF: Invests in an equally weighted portfolio of large cap gold miners. The equal weight mandate provides true sector exposure while simultaneously reducing the security-specific risk. ZJG - BMO Junior Gold Index ETF: Invests in smaller cap gold producers in North America, offering higher growth opportunities and a counterweight to rising geopolitical risk.

Private Debt

For access to private debt, consider ZFH as a proxy. It gives you exposure to high yield credit with a floating rate reset, which means the exposure benefits from tightening credit spreads. ZFH - BMO Floating Rate High Yield ETF: Receives a coupon in exchange for selling insurance on high yield bonds. Its unique features include:

• A liquid alternative to floating rate high yield senior loans (settlement on physical Floating Rate Senior Loans is T+15-25, thus they’re highly illiquid)
• Low correlation to other sectors of the bond market, such as Canadian and U.S. corporate, preferred shares and leveraged loans with minimal duration risk
• Holds Treasury bills as collateral, which will appreciate as rates rise (they are also form the basis of the premium calculation)

Democratization of Alternative Investments

Ultimately, there is little distinction in the appeal of alternative investments to pension funds versus the portfolios you manage. Both are influenced by the same factors driving fixed income performance (inflation and real growth); both are tied to the real economy, albeit with an added risk premium for equity, credit and liquidity — and both are hedged to inflation, since real assets are often indexed to inflation.

However, it’s very difficult to translate the benefits of a pension fund to those assets managed by investment counsellors and family offices. Real assets are often characterized as ​“two-tiered” investments, where the biggest institutional investors get first pick and the resources for direct investing. To level the playing field, particularly at a time when markets are faced with rising inflation and interest rates, ETFs provide the ability to dip your toes into the alts market in a simple and efficient manner, providing a modern twist to the traditional 60-40 portfolio.

To learn more about alternatives as a means to optimizing your portfolios, reach out to your BMO ETF Specialist.

¹ Lucia Mutikani, ​“Households squeezed as U.S. consumer prices accelerate; more pain coming,” Reuters, March 10, 2022.

² Sébastien Betermier, Nicholas Byrne, Jean-Sébastien Fontaine, Hayden Ford, Jason Ho, Chelsea Mitchell, ​“Reaching for yield or resiliency? Explaining the shift in Canadian pension plan portfolios,” Bank of Canada, August 2021.

³ Brookfield Asset Management Inc., Infrastructure, and Renewable Power & Transition.

⁴ Brookfield Public Securities Group LLC, International Renewable Energy Agency, as of December 31, 2021.