How alternatives passed the 2020 test

Advocates of alts say this year addressed many concerns head-on, offering key lessons for advisors moving forward

How alternatives passed the 2020 test

While advocates of alternative investing point to a history that stretches to ancient times, the contemporary universe of accessible, democratized alternative investments is largely a product of the past decade. During that years-long bull market run, experts in the space promoted alts as a diversifying group of uncorrelated asset classes, while critics called them an overpriced, illiquid and opaque set of products that might not deliver the promised ballast when a real test hit the market.

In 2020, that test came. In the wake of nearly 40% drops in major indexes and chaos in wider economies, alternative investments largely did what they promised they would, offering uncorrelated returns and downside protection for investors. Claire Van Wyk-Allan, director and head of Canada at the Alternative Investment Management Association (AIMA), sees alternatives as both a protector and a growth engine for investors this year.

“We learned three big lessons about alts in 2020,” she says. “First, they’ve passed the litmus test. The performance we’ve seen through the March and April volatility and since then has been a testimony to alternative products and their active managers, who are reducing risk and managing volatility. Second, investors increasingly see alternatives as an essential part of their portfolios. Since Q1, investors have been positive about alts and are generally adding exposure across the board.

“Finally, I think that this year has been a stark reminder that alternatives are going to be part of the recovery. We're still in this pandemic, and alternative investments fund the new economy and parts of the real economy that need capital right now. They also assist with short selling and indicating or flagging the end of an old business or an old economy.”

As an indication of alts’ overall performance, Van Wyk-Allan cites the Scotiabank Alternative Mutual Fund Index, which has outperformed the S&P/TSX 60 by more than 6% this year. She also points to one dealer’s alt-exposed portfolio, which saw an average 25% reduction of volatility and a 40% increase in risk-adjusted returns this year, compared to portfolios with no risk exposure. The numbers point to alts as a key tool in reducing volatility and providing downside protection – and therefore wealth preservation.

“A new model for portfolio construction will emerge,” says Belle Kaura, chair of AIMA Canada and CCO at Third Eye Capital. “[We see] a shift from the traditional 60/40 model, with alternatives making up approximately 10% of portfolios. Risk tolerance, liquidity constraints and time horizon will dictate how much of a portfolio is allocated to alternatives.”

This has also been a year of continued innovation in alternative products as new regulations opened the door to liquid alts, and mutual fund and ETF providers sought to provide far more accessible alternative products for investors. Van Wyk-Allan says AIMA is still working with regulators to ensure alternatives are made even more accessible in safe, responsible investment vehicles. She says one of the key benefits for investors in this process has been access to short-selling strategies, which allow them to benefit like never before from increased volatility and avoid potential portfolio disaster from secular shocks.

However, the rise of alternatives has not come without detractors. Critics have pointed out that the asset class is expensive, especially in a low-fee era of investing, and that many of the best-performing strategies in alts are still inaccessible to retail investors. Other critics cite unforeseen risks in alternative sectors or decry a lack of liquidity in the investments.

Van Wyk-Allan says 2020 has given alternatives the opportunity to address some of those criticisms head-on. The cost of management, she says, has proved to be a very good value, considering the downside protection offered by alts this year. Meanwhile, innovation on the alternative mutual fund and ETF front has improved accessibility, and AIMA is pushing to make these products more accessible to the MFDA channel. Finally, she believes downside protection in the spring and alpha through the rest of the year should quiet the risk critics.

As for the lack of liquidity – a criticism often levied at alternatives – Van Wyk-Allan says liquid alts have helped address that, but she disagrees with the premise that a whole portfolio has to be liquid. In March and April, investors saw traditionally liquid asset classes become illiquid due to the COVID-19 crisis, and Van Wyk-Allan argues that having some illiquid assets in a portfolio can have a long-term benefit.

For AIMA in particular, 2020 has been a year of outreach and education. The organization has added a suite of CE credit presentations, as well as an investor education video series designed to help advisors and investors navigate the complexities of the alternative space more easily. This tool will allow advisors to continue the conversation about alternatives with their clients into 2021 and the volatile times that lie ahead, Van Wyk-Allan says.

“March should be that test for clients,” she says. “Advisors should talk about how their portfolio performed – were they comfortable or stressed? If they were stressed in March, maybe they should be considering more portfolio insurance for the volatility that will lie ahead. Advisors should be speaking to investors, gauging that level of comfort and risk, and thinking about the right percentage of alts to include on an evergreen basis to achieve downside protection.”

How alternatives performed at the height of the COVID-19 crisis

Canadian hedge fund indexes versus broader market indexes, March 2020

Scotia Canadian Hedge Fund Index Asset Weighted
MoM return: -6.82%
YTD return: -6.92%

Scotia Canadian Hedge Fund Index Equal Weighted
MoM return: -9.99%
YTD return: -11.59%

S&P TSX Composite Index
MoM return: -17.74%
YTD Return: -21.59%

S&P 500 Index (USD)
MoM return: -12.51%
YTD return: -20.00%