What advisors need to know about liquid alts

Will you and your clients be part of the “biggest innovation” Canadian markets have seen in recent years?

That’s how Claire Van Wyk-Allan, director and head of Canada for the Alternative Investment Management Association (AIMA), describes alternative mutual funds. Known as liquid alts, these funds—which use alternative strategies such as shorting, leveraging and derivatives—will soon be available to retail investors, not only accredited investors, thanks to CSA’s new rules.

Those rules, effective Jan. 3, may be particularly timely for investors seeking downside protection, she says.

“We’ve been enjoying a very long bull market, but that can’t last forever,” says Van Wyk-Allan. “You need to include that diversification, risk reduction and non-correlated return piece in your portfolio.”

She adds that some Canadian pensions have upward of 40% of their portfolios allocated to alternatives. That’s a point repeated by Craig Machel, director of wealth management and portfolio manager at the Machel Group, Richardson GMP in Toronto, who says investors shouldn’t write off alternative strategies as inherently risky.

Many pensions and institutions have been investing beyond bonds, stocks and cash for a long time, he says. The new rules are great for advisors and investors who “haven’t been down the path of what else is out there,” he says.

David Picton, president and portfolio manager at Picton Mahoney in Toronto, expects some IIROC advisors who have avoided the regulatory burden of the offering memorandum (OM) regime will adopt liquid alts.

Likewise, Jason Mann, co-founder, partner and CIO at EdgeHill Partners in Toronto, says, “Prospectus funds change everything.” In addition to regulatory backing, “you get rid of the paperwork,” such as risk acknowledgement forms.

The framework for MFDA advisors involves existing proficiency standards in place for commodity pools, which will be updated.

Adoption will take time, however. As products are introduced, there will be a wait-and-see period as the market learns about the funds and managers, says Picton.

One factor that will affect the process is risk ratings, as new products have no track record. A Scotiabank white paper says dealers’ detailed processes for adding liquid alts to product shelves may result in “high risk” ratings, potentially limiting investment by advisors.

Still, the paper says liquid alts will likely grow as assets shift from existing mutual and hedge funds. Based on the U.S. experience, where regulatory changes in 2013 helped launch liquid alts, Scotiabank forecasts Canada’s liquid alts market could grow to more than $20 billion in five years—“a meaningful portion of the market.” Canada’s mutual fund market comprises $1.33 trillion, says Scotiabank; the hedge fund market, about $40 billion, says AIMA.

In the U.S., about 37% of U.S. retail advisors use liquid alts, finds research from Cerulli Associates. U.S. advisors’ mean allocations to alternatives in 2017 represented 7.2% of their total assets under management, compared to 5.7% the year prior.

Tips for investing in alts

For advisors who decide to use alternatives, “products have to make sense,” says Picton. That means advisors must ask themselves what a portfolio requires: an alpha or non-correlated strategy. Similarly, Mann says advisors should understand why they’re buying a product—what is it replacing in the portfolio? (Both Picton Mahoney and EdgeHill offer alternative funds.)

For example, a bond allocation won’t perform as usual when rates are rising, so liquid alts with a market neutral or arbitrage strategy, for example, can fill the gap, says Mann. Or, to cushion against equity volatility, long-short strategies could be employed.

While liquid alts aim to provide returns uncorrelated to traditional asset classes, some research shows that returns are “highly correlated” to the S&P 500, offering little protection in the case of a crash. This further highlights the importance of advisors thoroughly understanding these products.

When performing due diligence, Picton says advisors must look at a manager’s track record with a particular strategy, and strategy characteristics must be defined. Further, strong risk control should be in place, such as an independent risk committee that monitors portfolios.

Mann says that a risk management process should include constraints on the strategy: how big a position size can be, how much leverage is used, how risk is reduced and when. When liquid alts are used to reduce risk, a good manager should be first and foremost a risk manager, he says.

Another consideration is whether the manager is personally invested. “That’s a huge vote of confidence,” Mann says.

Picton notes a manager should have critical mass to maintain proper compliance, because regulatory burden requires scale. For example, to maintain fairness, a manager’s trade fill should be prorated across all of the manager’s funds.

Advisors who use these funds must also educate clients. “Talking to clients about defence takes a lot of work,” says Machel, describing the well-known client who monitors individual fund performance, not portfolio performance. When markets are up, that client might be inclined to sell a defensive alternative.

Machel tells clients that they won’t keep up with massive returns during market rallies, but neither will they lose all returns in a down market. Defence is a longer-term proposition, he says, and clients should understand it’s OK to have defensive strategies that don’t keep up with big returns.

“When markets get ugly […] people are going to be happy they own some defensive-position strategies,” he says.

Also read:

Liquid alts: hyped up or helpful?