Recent changes to Canadian mutual fund rules have spawned a wave of new investment vehicles called liquid alternatives. We’ve seen more than 50 new liquid alt funds launched in Canada as mutual fund managers clamour to attract new capital. The Canadian Association of Alternative Strategies and Assets estimates that up to $2 billion has been allocated to these funds already.
Proponents say these new funds will revolutionize how Canadians invest, while detractors warn that they will lead to unintended risks as managers add leverage and derivatives to traditional portfolios. So how should the uninitiated approach this new asset class?
First, let’s establish what liquid alternatives are and what they are not. Liquid alternatives are not direct investments in assets such as property, private equity, artwork or wine. Such investments typically cannot be bought or sold on a daily basis.
Rather, liquid alternatives allow managers to use traditional market instruments (bonds, stocks and commodities) in non-traditional ways. Liquid alt funds differ from traditional funds in a few ways, but the most significant are that they allow for the use of leverage and short-selling. Managers who have experience with these tools can use them to create a focused asset exposure that offers an attractive risk/reward ratio.
The problem is that these tools can be downright dangerous if used incorrectly, and not all funds are created equal. Asking a mutual fund manager to use leverage and short-selling is a bit like handing a bus driver the keys to a shiny new Ferrari. They will be tempted to test its limits, and you hope they don’t crash at the first wall. Taking levered exposure to a volatile asset class shouldn’t be the reason for employing a managed alt fund – a margin account will do that nicely and leave you in complete control.
Measuring the performance of a liquid alt is not always straightforward. The profile often does not fit well against an established benchmark index. Strategies can involve holding long and short positions with low net market exposure and may not follow broad markets in the traditional way. When bond and equity markets go through periods of strong performance, as they did in the first half of 2019, alternative investments appear to be underperforming. However, in the right hands, liquid alternatives can offer meaningful diversification while maintaining or even reducing the market beta of an overall investment portfolio. So how does one best evaluate these funds and the managers that run them?
First, assess the fund manager’s experience in investing with short-selling and leverage. Can they articulate clearly how they use these tools? How does the manager hedge against downside risks? Seasoned alternative managers will often have a track record of managing similar strategies, such as a hedge fund or a closed-end fund. Consider the similarity of the liquid alt strategy to the manager’s prior experience.
Second, keep in mind that the best liquid alternative strategies are not necessarily the ones promising double-digit returns, but the ones that offer competitive market returns with lower volatility. Low-volatility funds can often meet or beat the long-term returns of traditional strategies, but without the peaks and troughs along the way. That can be an attractive substitution for risk-averse investors, but also for risk-tolerant investors who are interested in allocating to high-beta strategies. A low-beta alternative fund, combined with a speculative asset, can replace core equity to boost potential returns without increasing expected volatility.
Finally, most investors in Canada are exposed to two key risks: stock markets and interest rates. If stock markets are rising and interest rates are falling, both equity and bond holdings are going up in value, and investors are happy. But if rates are rising and stocks are falling, as they did for much of 2018, investors become anxious. An alternative strategy that is uncorrelated to one or both those metrics can be a powerful addition that reduces the price swings of an overall portfolio – which means you and your client can sleep better at night.
In the midst of low yields and a mature economic cycle, advisors should welcome the opportunity to diversify away from marketcorrelated risks. You might not feel equipped to evaluate the range of strategies available, but by considering the three yardsticks above, you can uncover some attractive value propositions that offer real diversification and improve the risk-adjusted returns of your clients’ portfolios.
Andrew Torres is the founder and CEO of Lawrence Park Asset Management, a Torontobased alternative fixed-income manager. Torres has been using short-selling and leverage strategies for most of his 30-year career.