Alternative investment strategies, once available to only accredited investors through products such as hedge funds, are becoming increasingly accessible to retail investors through alternative mutual funds.
"One of the biggest benefits of alternative mutual funds is that they provide investors with enhanced risk reduction," says Jeffrey Burchell, fund portfolio manager and co-chief investment officer with Aston Hill Asset Management Inc. in Toronto, one of the largest providers of open-ended alternative mutual funds in Canada in terms of assets under management (AUM). "These funds are generally less correlated to the broader market and help decrease the overall beta and volatility of [a client's] portfolio."
Plus, adds Burchell, investors can access alternative strategies within a mutual fund structure that offers "benefits such as daily liquidity, no paperwork and no performance fees" - unlike products such as hedge funds.
The shift to alternative mutual funds comes in the wake of uncertainty about market conditions, says Dan Elsberry, senior managing director with Franklin K2 Advisors, a division of Franklin Templeton Investments Corp., in Stamford, Conn.: "As markets become a bit more challenging with the possibility of a correction in equities and a rise in interest rates, [we anticipate that] investors [will] keep adding to their alternative mutual fund holdings."
Although still relatively small in size, AUM in Canadian alternative strategies mutual funds, as defined by the Canadian Investment Funds Standards Committee (CIFSC), have grown by more than two and a half times in roughly five years to $1.4 billion as of July 31 from $520 in million as of Jan. 1, 2009, according to data from Toronto-based Investor Economics, a division of U.S.-based research firm Asset International Inc.
(A fund is classified as alternative strategies by CIFSC if short-selling exceeds 2% of AUM held in any one security or if total short positions exceed 10% of the total AUM; and/or the fund's investment mandate specifically includes use of alternative strategies.)
In comparison, U.S.-based alternative mutual funds have AUM of US$157.3 billion as of July 31, according to Chicago-based Morningstar Inc.
Based on a March 2014 survey conducted jointly by Morningstar and the financial publication Barron's, mutual funds are the vehicle of choice in the U.S. for accessing alternative strategies, with 2013 registering the strongest asset flows into alternative funds and the largest number of fund launches on record.
As of July 31, Morningstar Canada lists 83 alternative strategies mutual funds, including various classes of 38 funds offered by 21 providers.
About a third of these funds are prospectus-based, requiring minimum initial investment of $2,000 or less. The remaining funds in the category are sold by offering memorandum (OM) to accredited investors (although they may be classified as mutual fund trusts). Part of the reason for an OM structure is to allow for the use of leverage, which is not permitted by prospectus-based mutual funds.
Alternative mutual funds typically use a variety of strategies that are associated with hedge fund investing, among them long/short equity, market-neutral, relative value, event-driven, global macro and multi-alternative (the last of which combines different strategies in a single fund). Long/short equity is the most popular strategy.
The primary objective of an alternative mutual fund is to provide downside protection and not beat the market, says Elsberry.
This means, adds Burchell, that "investors might have to give up some upside returns for decreased volatility and lower downside risk."
But that does not mean that these funds do not provide strong upside returns. For example, Aston Hill Growth and Income Series X Fund, one of the best-performing open-ended alternative mutual funds listed by Morningstar Canada, returned 20.3%, 15.9% and 15.7% over the one-, three- and five-year periods, respectively, ended July 31.
The tools this fund uses to achieve its objectives, says Burchell, include shorting, options strategies, cash as an asset class and active management of currency hedges via forward contacts - much like in other Aston Hill funds.
Norrep Market Neutral Income Fund Class F also seeks to provide downside protection without beating the market. Keith Leslie, portfolio manager and chief risk officer with Hesperian Capital Management Ltd. in Calgary, who manages this fund, says its investors expect a minimum yield of 4% - and are "ahead of expectations."
The Norrep fund, says Leslie, which invests in stocks as much as possible, uses long/short strategies within market subsectors. For example, the fund might go long on one bank and short on another. The fund also invests in "short duration investment-grade bonds, which it aims to hold to maturity" - the yields from which cover the fees of the fund.
The Norrep fund returned 7.2% and 10% over the one- and three-year periods, respectively, ended July 31.
Coming in the November issue: Accessing alternative strategies through exchange-traded funds.
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