Liquid alternatives funds – known as “liquid alts” – have been available to Canadian financial advisors and investors for just more than a year, but they have spared no time adding these products to portfolios.
Rules that allow liquid alts to be sold in Canada came into effect on Jan. 3, 2019. And according to data from the Investment Funds Institute of Canada, there was a combined $8.4-billion in assets under management (AUM) held in liquid alts mutual funds and exchange-traded funds (ETFs) as of year-end. (That figure includes commodity pools that were reclassified as liquid alts in 2019.)
Demand is expected to grow significantly as the market for these products is forecasted to rise to as high as $100-billion in AUM within five years, says Claire Van Wyk-Allan, director and head of Canada for the Alternative Investment Management Association (AIMA).
Driving liquid alts’ popularity is their ability to offer alternative strategies such as short-selling, derivatives, leverage and others that were previously available only via hedge funds to qualified, typically high-net-worth clients, to a wider audience through a mutual fund or ETF.
“The primary shift is bringing these strategies to retail investors,” she says.
Still, liquid alts are often more complicated than traditional mutual funds or ETFs, Ms. Van Wyk-Allan adds.
What’s more, a recent U.S. study suggests that even advisors may not be using liquid alts appropriately. BlackRock Inc.’s Fall 2019 Advisor Insights Guide revealed that 30 per cent of U.S. advisors’ portfolios contained at least one alternative product, with 76 per cent advisors surveyed saying they’re using these products to reduce risk in clients’ portfolios.
Yet, the report also noted that almost half (48.5 per cent) of advisors employed models with high correlations to stock market returns. So, rather than providing diversification and non-correlated returns, the alternative strategies used may increase equities exposure – only with higher fees than index-tracking funds.
Although only U.S. advisors were surveyed for this report, it points to the potential issues for advisors in Canada who choose to use alternative strategies, says Belle Kaura, vice-president of legal and chief compliance officer at Third Eye Capital Corp. in Toronto.
“The survey brings to mind the question: How do advisors use these [products]?” says Ms. Kaura, who’s also chair of AIMA Canada. “That speaks to the challenge that liquid alts are a new product with which many Canadian advisors may not be all that familiar.”
She adds that alternative strategies generally serve at least one of the following roles in a portfolio: hedging risk, diversification, reducing volatility and enhancing returns.
Strategies can be directional or non-directional to markets, ranging from high underlying exposure to equities to none, with “a spectrum of risk return profiles,” Ms. Kaura says.
Most advisors understand why alternative strategies make sense in a portfolio, but many have never used hedge funds – let alone the tools underpinning them, like derivatives. Furthermore, given the variety and complexity of liquid alts, finding the right products for clients is challenging.
For advisors who are accustomed to providing alternative products available under an offering memorandum (OM) to high-net-worth clients, liquid alts are familiar territory, says Francis Sabourin, director, wealth management, and portfolio manager with Francis Sabourin Wealth Management at Richardson GMP Ltd. in Montreal. Advisors who aren’t should look to proven strategies.
“You have to play with the guys who have been in the business for years,” says Mr. Sabourin, who manages Diversified Alternative Income Portfolio, an OM fund
That’s why Grant White, portfolio manager and investment advisor with Endeavour Wealth Management at Industrial Alliance Securities Inc. in Winnipeg, says he chose Dynamic Alpha Performance II Fund for suitable clients. The fund, which is managed by Noah Blackstein, vice-president and senior portfolio manager at DynamicFunds, is a liquid alt modelled after Dynamic Alpha Performance Fund, an OM fund with a track record dating back to 2002.
Mr. White says the fund applies a long-short strategy that takes concentrated positions in a handful of companies and hedges their downside risk. With annualized returns of about 5 per cent since inception, he notes the liquid alt version provides consistent returns while reducing volatility.
“It’s not a get-rich fund, but rather a keep-you-rich fund,” he says, adding that liquid alts make up about 10 per cent of his clients’ portfolios.
Ms. Kaura says that of the 90 or so liquid alts with filed prospectuses in Canada, “more have alpha strategies with far fewer market-neutral strategies coming to market – likely a result of the restriction on maximum shorting.”
The higher number of return-enhancer products may reflect what has occurred in the more mature U.S. market, where many advisors are using alternative strategies that seemingly amplify equity risk.
“Yet, even funds with underlying equity exposure, such as long-short funds, can provide non-correlation to the stock market because of the derivatives, hedging and shorting tools that are available,” she says.
That said, these strategies “can look like a black box” to advisors new to the segment, Mr. White says. “It’s important to look under the hood … and I suspect some [advisors] may not do enough of that.”
Understanding how a liquid alt works is essential. So too is recognizing how it differs from its OM equivalent.
To provide daily liquidity, the investment is likely “a more conservative version and might not generate the return you expect with the mother [OM] product,” Mr. Sabourin says.
Indeed, some liquid alts should be considered “hedge funds lite,” Ms. Kaura says. That’s because they involve limits on leverage (up to three times net asset value [NAV]), and on short selling (up to 50 per cent of NAV).
Consequently a market-neutral liquid alt may not be “as purely market neutral as you may see in the OM world.”
Nevertheless, Ms. Van Wyk-Allan says liquid alts are increasingly important pieces for client portfolios.
“There needs to be a certain standard of care for any advisor investing in alts, but there is far more risk in being in a long-only portfolio – especially given how late we are in a bull market,” she says.