The search for enhanced risk-adjusted returns, reduced portfolio volatility, greater diversification and uncorrelated assets is leading more clients into alternative investment strategies and products.
“Several factors,” says James Burron, chief operating officer of the Toronto-based Alternative Investment Management Association of Canada (AIMA Canada), “among them lower yields from traditional bonds, equities markets that are range-bound and the desire for uncorrelated sources of return, have led to substantial growth in alternative investing.”
Burron suggests that there is scope for alternative investing to continue to grow, as the size of the Canadian market – with assets under management of about $35 billion, up from $15 billion five years ago – is still relatively small compared with the US$2-trillion global market. According to an AIMA Canada publication: “Only 15% of the roughly 250 Canadian alternative funds post assets under management in excess of $100 million.”
Alternative strategies typically encompass investments in a broad spectrum of products, among them hedge funds, private equity, managed futures, structured products, mortgage and private lending, and hard assets such as physical commodities and real estate. Mutual funds that use long/short strategies also have become increasingly popular alternative investments.
In fact, says Jordan Zinberg, managing director and portfolio manager with Donville Kent Asset Management Inc. of Toronto, alternative investing may include “anything that is not considered plain vanilla, such as long-only investments.”
Typically, most alternative strategies use derivatives, futures, options, leverage, arbitrage or short-selling to generate absolute returns that are independent of an index or benchmark over a defined period of time.
These investments are different from more popular, traditional investments that seek to generate returns that are measured relative to a benchmark or index.
Investing in alternatives is about choosing uncorrelated assets that do not move in the direction of the traditional markets, says Jaime Purvis, executive vice president, national accounts, with Horizons ETFs Management (Canada) Inc. in Toronto, in order to “create an effectively diversified portfolio.”
The use of alternative strategies is premised on the fact, says Burron, that they “provide an entirely different set of risks” compared with investing in traditional investments, such as equities and bonds.
Equities investments, for example, follow the direction of the market, Burron adds, which historically has “delivered returns within a certain range,” albeit with volatility and uncertainty.
The idea behind alternative strategies, as Craig Machel, vice president and portfolio manager with Richardson GMP Ltd. in Toronto, points out, is to “invest in assets that have a greater certainty of making money, without relying on what the market does.”
Investors these days also are apprehensive about fixed-income securities, which traditionally have offered safety, says Purvis: “The risk in bonds has changed, to the extent that they are no longer a safe haven.”
If currently low interest rates increase – as they are expected to, he adds, – then bond prices will drop, leading to losses for investors.
Hedge funds traditionally have been the most popular type of alternative investment. These funds use complex strategies ranging from low- to high-risk. Hedge funds do not tend to move in sync with the markets, says Zinberg, and thus can be used to “smooth out portfolio returns.”
But mutual funds that use long-short strategies have also gained traction in the alternative investment marketplace. In the U.S., for example, a survey conducted by Morningstar Inc. and Barron’s magazine in March 2014 found: “For the fourth year in a row, long/short strategies garnered the most interest, but growing apprehension toward the bond market has also contributed to blistering growth in non-traditional bond funds.”
Investors also are turning to hard assets such as physical real estate as alternative investments. Real estate is uncorrelated to other asset classes, says Burron, and typically is “a long hold.”
In addition, he adds, the value of real estate is appraised periodically – unlike the value of stocks, for example, which are subject to daily market forces.
Real estate can provide capital gains and a reliable income stream, but there is broad consensus that such investments are subject to liquidity risks.
Similarly, other alternative investments may have liquidity risks. For example, hedge fund investments can be subject to an initial lockup period that can range from three months to a year or longer. As well, investors may have to provide notice of redemption and may not have access to their money for periods ranging from a few weeks to several months.
The use of leverage, derivatives and short-selling strategies raise the biggest concerns about alternative investing. In each case, such an investment can suffer a substantial loss if the investment manager makes a wrong call.
Although the benefits of alternative investments might be attractive, not everyone can invest in them. They are sold primarily in the prospectus-exempt market, which makes them available only to investors who can make a minimum investment of $150,000 or to accredited investors who must have net assets of $5 million or financial assets exceeding $1 million, or a net annual income exceeding $200,000 (or $300,000 when combined with that of a spouse). However, some hedge funds and alternative mutual funds may have a minimum investment as low as $25,000 for accredited investors.
Higher fees are another concern with investing in alternatives. Typically, these investments charge both management fees and performance fees that are based on gains generated by the investment above a specified level.
If the mention of alternative investments and strategies elicits blank stares from your clients, you need to take extra care that they understand how these products work, as well as about their risks, fees and limitations.
One basic message to convey to your clients at the outset is that alternative investments represent a source of return that is not hitched to the direction of traditional markets, says Craig Machel, vice president and portfolio manager with Richardson GMP Ltd. in Toronto. You can use historical returns data provided by alternative investment managers in combination with an explanation of the merits of specific strategies to illustrate the potential returns of alternative products.
For example, Machel focuses on a “range of return expectations” strategy to explain what different products offer, both traditional and alternative. He illustrates the range of potential upside and downside returns of various products and the impact of varying market conditions.
Understanding that some alternative investments may not be as liquid as traditional investments is one of the biggest challenges for many clients. You should ensure your clients fully understand their redemption rights and that they are comfortable with not having immediate access to their investments.
Jordan Zinberg, managing director and portfolio manager with Donville Kent Asset Management Inc. in Toronto, makes sure that his clients understand how alternative investment managers are selected, including their track records and investment processes.
Also, you’ll need to explain why the fees for alternative investments are higher than those for traditional investments. Alternatives typically charge performance fees, based on the manager’s ability to provide returns above a predetermined level, on top of the management fees. Assuming the manager achieves that level of performance, your client typically is charged a management fee of, say, 2% and a performance fee of 20%, says James Burron, chief operating officer of the Alternative Investment Management Association of Canada.
This is the first article in a three-part series on alternative investments.
In the October issue: Accessing alternatives via mutual funds.
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