The stock and bond markets are jittery, to put it mildly. So, let’s review the alternatives.
You can practise your guitar incessantly, making you the millionaire rock star you always knew you could be. Or, you can write daily diary entries on love and hope and turn yourself into the next best-selling Instagram poet. Either could happen. Let’s not kill the dream.
But a more button-down alternative, in these times of turbulent financial markets, is a class of investment newly introduced in Canada called liquid alternative investment funds. Or liquid alts, in Bay Street lingo. Think of them as hedge funds light, open to the public. And, as more of these become available, they will likely focus on derivatives and similarly complex financial instruments, which bet on what direction an underlying financial asset will go in terms of value. For instance, a liquid alt might have long-short equity strategy, making bets on both stock market gains and declines (i.e. liquid alts are for people with considerable financial know-how and not for the faint of heart).
Yet, alternative investing as a general strategy is nothing new. Real estate, private equity or other assets have long been used to hedge one’s stock and bond market bets, because they are less correlated to financial markets. So, if the markets are having a rough ride, you can rely on other investments to provide some cushioning.
Yet the problem has been that complicated alternative investments aren’t traditionally as liquid as, say, an ordinary mutual fund. They have been more difficult to buy and sell, and regulations in Canada had made complex, alternative investment vehicles more of a tool for higher-net-worth, accredited investors, out of the reach of ordinary ones.
This has changed somewhat with new rules introduced early this year in Canada, allowing the introduction of liquid alternative investment funds which can be bought and sold more like mutual funds. They are complex financial alternatives packaged for the mainstream.
The Alternative Investment Management Association, which represents this side of the investment industry, sees this as “an absolutely huge, transformative disruption to the industry,” said Claire Van Wyk-Allan, AIMA’s head of Canada. She added that the focus of the funds will likely concentrate on derivatives (investments that aim to profit from the changing prices underlying assets, indexes or securities), but in a more restricted way than actual hedge funds.
Alternative investing is already a busy corner of Canada’s investment business. According to the analytical firm Strategic Insight, cited in a report from Mackenzie Investments, alternative assets managed in Canada grew to $212-billion at the end of 2017 from $93-billion in 2012. This will likely only increase as the new liquid alternative funds gear toward ordinary investors.
“This is the most liquid format that you can buy in alternative strategies,” she said. The new rules allow hedge fund-like alternative investments to be packaged “in a more constrained, lighter format, so that the average Canadian investor, who is not accredited, will be able to invest in these types of strategies,” Ms. Van Wyk-Allan said.
“Where we anticipate there will be a large influx of assets are in balanced fund, for example, which will be able to include alternative strategies, as part of their underlying portfolio,” she added.
What’s important, however, is not to see these as get-rich-quick alternatives to stocks and bonds. Instead, they are about managing volatility. “Alternative investments, contrary to what a lot of people think, aren’t intended to earn higher rates of return,” said Daniel Girard, a portfolio manager at CIBC Wood Gundy and managing partner at Girard, Pilkey and Associates Wealth Management in Waterloo, Ont. “They’re intended to earn the same rate of return, with lower volatility.”
So, for a 30-year-old looking to build an investment portfolio over time, or a 60-year-old nearing retirement who is more interested in wealth preservation, alternative investing doesn’t mean changing an investor’s underlying strategy. It’s just about evening out the rough edges and adding more investment options, Mr. Girard advised.
For instance, a 30-year-old, who is willing to take risks and is looking for growth, might be interested in such alternatives as bitcoin or cannabis investments, both hot investments at the moment with potentially high returns, yet both exceedingly risky. “Let’s call it an alternative investment in innovation,” Mr. Girard said. “But [the investor] might also do some fancy shorting and derivative investing to lower the risk of being in a high-risk investment. So, it’s doing something different than just stocks and bonds.”
Similarly, a 60-year-old could look at alternative investments as a way to lower risk and volatility. Let’s say the older investor already owns income-producing bonds and dividend stocks, so income from investments isn’t a problem. And yet, he will still need some asset growth because he may live another 30 years. In that case, “low volatility, low-risk alternative investments is a really good choice,” Mr. Girard said.
That’s the theoretical case for alternative investments. Mr. Girard expressed reservation, however, about the new breed of liquid alternative funds catering to a wider market.
“The problem is that they’re watering them down,” Mr. Girard said. “They are taking the element that made alternative investments potentially good, and they are tweaking them, so that they have liquidity features and various things. But the things that made them good in the first place, they are taking away. So, they likely, in my opinion, end up being not very effective investments.”
In other words, if alternative investments are made for everybody, how alternative are they really?
William Macinnes, investment advisor at Canaccord Genuity Wealth Management and Kosnik Macinnes Wealth Management Group in Toronto, emphasized the importance of asset allocation when talking about alternatives. They at least let you put more eggs in different baskets.
“Studies have shown that 40 per cent to 90 per cent of portfolio volatility can be attributed to asset allocation, as opposed to security selection. And so, for the average investor, with alternatives becoming increasingly accessible, means a greater breadth of asset options during the asset allocation process,” Mr. Macinnes said. “So, more options available with lower correlation [to stocks and bonds] should result in improved overall diversification.”
He agreed with the point that alternatives aren’t meant to change one’s risk tolerance and investment goals. Alternatives, ideally, are about providing more options to meet those goals. Yet, they also add complexity.
“Because of the often complex nature of these strategies, a great emphasis must be put on an increased level of due diligence and oversight necessary to fully understand the risks and manage them accordingly,” Mr. Macinnes said.