Red and blue market performance graph

While most asset managers are anxiously hoping to wring out another year of gains from this aging bull market, those in Canada’s new liquid alternative mutual fund market may not mind a little turmoil.

“Liquid alts” – mutual funds that use alternative strategies such as short-selling, leveraging and derivatives – became available to retail investors at the beginning of 2019. Although strategies among the funds differ, last year’s strong markets were challenging for active approaches that aim to remain uncorrelated to the broader market.

The Scotiabank alternative mutual fund index showed year-to-date returns of slightly less than 5% at the end of November 2019. That compares with almost 19% returns for the S&P/TSX composite index and more than 25% for the S&P 500 through the first 11 months of 2019.

“The markets have been on a tear both in Canada and the U.S., and anytime you have a product that hedges, it would be very difficult to keep pace,” says Daniel Dorenbush, managing director and head of Canadian prime services at Toronto-based Bank of Nova Scotia. But the products still are executing their strategies, he says, generating returns while providing downside protection.

In May 2019, when the S&P/TSX com- posite dropped by 3.28% and the S&P 500 dropped by 6.58% due to heightened trade tensions between the U.S. and China, the Scotiabank liquid alt index fared better: dropping by 1.21%.

David Picton, president of Toronto-based Picton Mahoney Asset Management, says a market turn in which “riding beta” no longer works could be the biggest catalyst for liquid alt funds. “The ones that deliver on their objective of being different are the ones that [will] really start to pick up some [market] share,” Picton says.

A recent report from Scotiabank states the liquid alts market could reach $20 billion within five years; other estimates put the number as high as $100 billion. As of Nov. 30, 2019, new liquid alt funds had slightly less than $7 billion in reported assets under management, Dorenbush says – a mix of new assets as well as transfers from existing alternative products, which boosted liquid alts in their first year.

Assets held in Canadian products are spread among almost 100 funds and 32 providers, ranging from large asset managers (Toronto-based firms such as Bank of Montreal, Canadian Imperial Bank of Commerce [CIBC] and AGF Management Ltd.) to small shops from the alternative space, according to Toronto-based Fundata Canada Inc.

Liquid alts are attracting assets that may previously have gone into hedge-fund offering memorandum (OM) products, as well as attracting investors new to the alternative investments space, Dorenbush says.

However, there’s still apprehension. While fund manufacturers may rate new products as low- to medium-risk, some dealers view them as riskier.

“This is because of the complicated management style that many of these [portfolio] managers employ, thus forcing the hand of compliance departments to default the risk rating to ‘high risk’,” states a November report from Toronto-based Richardson GMP Ltd. “In a way,” the report continues, “this rationale makes sense because of how much latitude there is between a liquid alt in comparison to a traditional mutual fund” – although that means funds with a mandate to reduce volatility could end up classified as “high risk.” The ratings will make growth over the short-term difficult, the report states.

Then there are the fees. In addition to the management expense ratio, many alternative mutual funds charge performance fees based on positive returns above a perpetual high water mark or have “hurdle rates” above which a fee is charged, states a September 2019 report from CIBC.

Claire Van Wyk-Allan, head of Cana- da with the Alternative Investment Management Association (AIMA), says the average performance fee for alternative mutual funds is around 8%.

Liquid alts’ limited or non-existent track records also are an impediment to landing on dealers’ product lists. Picton says most dealers want to see at least three years of performance. This gives an edge to hedge fund providers with liquid alt funds that match strategies that existed in another form before the new products were introduced.

“The more closely related your product is to what you’ve had in the past, the more reasonable it is for people to have comfort that you know what you’re doing, and they can see how you’ve done through tests that occurred along the way,” Picton says.

The Richardson GMP report agrees that the “least concerning” products in the market are from portfolio managers whose previous strategy fits within the new liquid alt rules. “However, approach with caution those solutions based on an [OM product] that had to be drastically modified to meet the new criteria, or others that are novel products launched to ride the early momentum,” the report adds.

The number of new products and the range of strategies offered adds to the confusion, Picton says. “We have a plethora of these products coming out promising all kinds of different objectives and they’re all kind of being lumped in to one asset class called ‘alternatives’,” he says.

However, Dorenbush says, progress has been made on educating financial advisors and dealers.

Another potential source of growth for liquid alts is their inclusion in “fund-of-fund” products, the CIBC report states.

But market conditions could still be the vital factor. “The space has a lot of runway to grow,” AIMA chair Belle Kaura says. “As investors prepare for a downturn, there is tremendous opportunity.ยป