Liquid alternative funds, a.k.a. liquid alts, are a new product group in the mutual fund universe. Like hedge funds, they can use leverage and concentrate holdings to exceed the 10% cap common for single assets in Canadian mutual funds. They will trade at day-end prices, settle in two days and have assets different from the long positions of conventional mutual funds. At the end of the first week of March 2019, there were 32 liquid alts operating in Canada. More are sure to come.
Introduced in Canada in late 2018, liquid alts expand the offerings of mutual fund companies and give small investors a shot at hedge fund strategies that are usually the privilege – and risk – of qualified investors who have a few hundred thousand dollars to buy into exotic or illiquid assets, such as farmland or infrastructure. To date, these funds have seed money, as required by regulations. It’s premature to judge actual sales.
Liquid alts expand the investment range of mutual funds – call them “hedge funds for everybody.” They can be structured with shorts and leverage to zig when everything else seems to zag.
The market for Canadian alternative strategies, once the turf of institutional and high net-worth investors, will expand to anyone with $500 to invest, although Toronto-based Connor Clark & Lunn Financial Group Ltd. (CC&L) has set a $5,000 minimum investment hurdle for its funds. Borrowing will be limited to 50% of net asset value (NAV). Shorts will be held to 50% of NAV. Leverage will be limited to three times the sum of short securities, plus short cash, plus the notional value of derivatives divided by net asset value. Finally, illiquid assets will be limited to 10% of NAV. Liquid alts will have fees based on management expense ratios and trading costs. Managers will be able to hold as much as 20% of fund value in any one asset, rather than the 10% limit applicable to most mutual funds.
Well-known asset managers that have brought liquid alts to market include Mackenzie Investments, CI Investments Inc. and IA Clarington Investments Inc. (all based in Toronto) and, in the ETF space, Montreal-based Desjardins Global Asset Management Inc.
Most of the new funds do not charge performance fees. Michael Schnitman, senior vice president, product, for Mackenzie Investments in Toronto, says only conventional mutual fund fees based on NAV apply. “We did not choose performance fees. Our fee structure is flat and should be attractive.”
CC&L, however, will charge 1.5% management fees for Series A and 0.50% for Series F for its Alternative Canadian Equity Fund and then add a 20% performance fee over a defined benchmark, such as the rise in the S&P/TSX average. For most liquid alts, average fees are about 2.5% for Series A units and about half that for Series F units.
Financial advisors will have more to offer clients, but the concept of being long or short with attendant borrowing costs, leveraged or not, poses challenges. “The flexibility rules that seem to be part of liquid alt mandates mean to me that I cannot be sure of what the fund has or is doing at any time,” says Graeme Egan, president of CastleBay Wealth Management Inc. in Vancouver. “That is a red flag for me because I cannot be sure of the quality of holdings, or if there would be a change of strategy in the short term. All that I can have as a portfolio advisor is faith in the liquid alt manager. I would get a monthly or quarterly report after the fact. I don’t feel comfortable with that. Further, we have a fiduciary duty to know our product and, while I am sure that these offerings are compliant with applicable rules, the mandates are too broad for our use in client portfolios.”
The theory of an alternative asset class, especially one that allows a heavy dose of shorts, ought to be a portfolio stabilizer. To the extent that shorts compensate for down periods in markets, that should work. The idea of different asset classes such as bonds and real estate, shorts and even non-financial assets adding safety to growth is accepted financial economics. But acceptance by investors and advisors is another matter of hope vs fear.
“It’s very early in the life of this flavour of investment to make a judgment of their popularity,” says Dan Hallett, vice president and principal at Highview Financial Group in Oakville, Ont. “It’s also a bit early to assess the uptake or interest from advisors. Sometimes it’s hard to distinguish if products are launched to meet unmet demand or if product manufacturers create the demand through branding and marketing. I’ve seen examples of both over the past 25 years. I’m not sure which one this is yet, but my guess is that it’s the latter.”
Adoption may also be slow due to the additional training required of advisors selling liquid alts. And there is a question of novelty. Segregated funds, with minimum guarantees of return of initial investment after prescribed hold periods, resemble hedged assets with added asset-protection features of insurance contracts. Two decades ago, Canada had a handful of hedge funds, but none worked out well, Hallett adds.
In 2008, the rush to wind down leveraged positions created markets that could not match bids and offers. In dire straits, liquid alts might find themselves cash poor in spite of rules limiting their leverage and how far they can venture in illiquid assets.