One risk strategy to consider: barbell investing

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Financial experts frequently stress the importance of maintaining a balanced portfolio. Often, the strategy to achieve that goal will prominently feature investment instruments of moderate risk. But another approach that some ultra-high-net-worth investors, including family offices, might want to consider is barbell investing.

The barbell approach is analogous to weightlifting equipment, with balancing weights on either end of the bar. It involves placing higher risk investments on one end, offset by very safe investments at the other end.

Mindy Mayman, a Montreal-based partner and portfolio manager with RFO Capital Inc., a subsidiary of Richter LLP, and part of the Richter Family Office platform, says that barbell investing works with various instruments.

Barbell investing can work with various financial instruments

The higher end risk concentrated at one end of the barbell could, for example, consist of high-risk stocks, private equity or venture capital, while the lower end risk could include instruments such as high-quality blue-chip stocks, investment grade bonds, cash, mortgage funds, or rental real estate, she notes.

“When we speak about risk, we are typically talking about the risk of volatility or market fluctuations,” Mayman explains. For example, for higher volatility risk “we typically focus on areas where we think that the long-term returns are going to be outsized even if there is fluctuation in the short term,” she elaborates.

Mayman says that when working with high-net-worth clients, part of her investment philosophy is to expose their portfolio to private investments beyond traditional stocks and bonds.

“We will explore things like private credit, development real estate and venture capital. All of these areas are a little bit harder for an individual that is less well-off financially to access,” she elaborates.

“Most of the clients we work with are entrepreneurs, and they have a very good understanding of risk in the sense that they have typically built businesses. They’ve had to take risks all their life, so are often willing to take calculated risks to do the best they can with their capital. Therefore, they are interested in these higher risk, higher return type of investments,” Mayman says.

Individual investing styles and willingness to pair aggressive and conservative approaches

Mike Stritch, chief investment officer with the BMO Family Office in Chicago, says the barbell approach to investing boils down to individual investment style and the willingness of an investor to pair a more aggressive investment profile with a very conservative one.

In general, he says, low-risk investments include cash and/or high quality fixed income investments, such as individual bonds held to maturity, used as wealth preservation capital. Higher risk investments include private equity, such as private investments or venture capital.

“What I typically see when this comes up would be something in line with private investments, coupled with very safe cash and/or fixed income instruments to create that barbell type structure,” says Stritch.

He notes that many ultra-high-net-worth investors have made their money through a successful private business venture and are uncomfortable with transitioning from investing in an enterprise where they are used to having a lot of influence on the financial outcome, to investing in public equities whose stock performance is subject to many factors beyond their control.

Investing approach also depends on macroeconomic factors

Risk is not the only determining factor that investors need to consider when determining what instruments to include in a barbell portfolio. Another key factor is the current macroeconomic environment, including whether rates are stable or rising, says Richard Croft, principal of R. N. Croft Financial Group Inc. in Toronto.

For example, “in a rising rate environment as we are in right now, we would generally expect value stocks to do better. In a high-growth environment we would expect growth stocks to do better if interest rates are remaining where they are, or not rising quickly,” explains Croft.

The key metric for fixed-income investments is the term to maturity. Typically, long-term bonds are higher risk than shorter-term bonds and so barbell investment decisions need to take into account how to weight long-term vs. short-term maturity bonds, Croft explains.

Examples of stocks that would fit into the high-risk end of a barbell portfolio include equities that are trading at fairly high multiples and that are leveraged and carry debt. The job of a money manager is to mitigate as much of the risk as possible on such investments so that an investor will stay invested for the longer term, says Croft.

“Attempts to mitigate risk means dampening volatility. Stocks with higher-than-average debt levels tend to be more volatile. Adding value stocks that are typically less volatile should smooth out the volatility within the overall portfolio,” he elaborates.

Due diligence and considering the pros and cons of barbell investing

The pros of taking a barbell approach to investing include the potential to generate a higher long-term return with a little bit more stability than simply investing in equity market indices, says Mayman.

Stock market returns (beta) can be generated cheaply through the use of exchange-traded funds. So the goal with strategies such as barbell investing is to achieve a higher return, or generate alpha, she explains.

However, due diligence is required to ensure the allocation to each high-risk investment is such that even if it doesn’t produce the desired return, or it generates some loss, the size of that allocation will not harm the overall portfolio in a material way, says Mayman.

Diversifying high-risk investments and giving them time to work by keeping them long-term also increases the chances of success, she adds.

Croft says there are four elements of diversification in a portfolio.

The first three elements are the asset allocation or mix on assets like stocks, cash, gold, commodities and real estate; the geographic positioning, such as how much is allocated in Canada, the U.S. and internationally; and diversification of industrial sectors.

Barbell investment decisions factor into the fourth element, which is investing style. An example of an investment style decision is whether to select investments based on momentum versus value.

Momentum stocks do better when the economy is strong, there are low or declining interest rates, and strong consumer demand and stable prices. Value stocks tend to do better in an economic environment where growth is slowing, rates are rising and demand is falling, Croft explains.

Broad stock indices, such as the S&P 500 or the TSX 60 are really a composite of the barbell approach because they’re weighted in a passive manner across value and growth, and the index itself has all four levels of diversification, says Croft.

The pros of taking a barbell approach include the ability to “align it very precisely to risk tolerance to say, ‘If I’m going to be very aggressive in this part of the portfolio, under a worst-case scenario – let’s say if there was a significant capital impairment, I know that I’m comfortable with that because this pool of fixed income and cash is here.’ It helps give the client peace of mind,” says Stritch.

On the con side, a family might find that if it has too many non-liquid investments, and ends up needing to access that capital, they will face liquidity risk. The barbell approach might also create certain inefficiencies like potential missed opportunities with more traditional types of investments, such as in traditional public markets, he notes.

High-net-worth clients are acquainted with investment risk

Mayman typically encourages a barbell approach to investing with her clients. “We believe that if we build the portfolio appropriately and if they can have their lifestyle needs met, then it does allow them to be more patient and more disciplined with the higher risk investments,” she explains.

The barbell approach can also be thought of as a pyramid, with below-risk investments forming the underlying foundation that clients can draw on for cash flow and lifestyle money. The top of the pyramid would involve high-risk investments, which can be aspirational to grow the portfolio to help reduce dilution of wealth through the generations, says Mayman.

And then the middle investments on the pyramid would serve as the bar if converting to a barbell analogy. Those could be used to, for example, try and keep pace with inflation. Examples of typical investments that keep pace with inflation include ETFs, rental real estate, and variable-rate debt, she says.

Many families, through analyzing their preferences and willingness to accept risk, are willing to take on more of a barbell type of approach to investing in terms of how they allocate the types of investments they want in their portfolios, Stritch says.

“I encourage many of our family office clients to think about investments through the behavioural lens,” says Stritch.

He asks them first to consider the amount of wealth preservation their family will need in a worst-case scenario.

“From there we have the measured accumulation, which is going to be your traditional equity investments, perhaps some high-yield fixed income. And then you have this kind of wealth generation or aspirational capital, and that’s what I would put into more of that high-risk bucket,” he adds.