New Liquid Alt Regime

The game changing liquid alternative regime came into force on January 3, 2019. The new rules represent the successful culmination of years of advocacy by AIMA.  Retail investors, for the first time in Canada, gained access to alternative strategies that use complex investment strategies. Liquid alternatives (“liquid alts”) can employ leverage through cash borrowing, short selling and specified derivatives up to an aggregate limit of 300%. The democratization of liquid alts gives all Canadian investors access to investing strategies that affluent and institutional investors have always had at their disposal. Canadian pension plans, among the world’s most admired, successful and influential investors, have a long history of using alternatives to build world-class investment portfolios. Liquid alts are filling a gap between public long-only strategies and private be-spoke investments that not everyone has access to. The new rules levelled the playing field with the US and the UK, where alternatives have been available to the retail segment for many years.

Market of Products

We are year into the launch of liquid alts in Canada. There is a burgeoning market for liquid alts. The liquid alt market has already reached close to $7 billion in AUM. Advisers and investors are showing a real interest in the liquid alt space. A flood of products have come to market. Early entrants who sought exemptive relief were able to launch by end of 2018, even before the new regime came into effect, and by mid-2019 there were 40 liquid alt products.  There are now almost 100 funds on the market, including ETFs, launched by over 30 fund companies.[1] There is a growing suite of liquid alt funds and strategies investors can choose from. Market entry of liquid alts has been dominated by bank-owned and large independent fund companies, collectively accounting for over two-thirds of AUM. Boutique hedge funds are bringing in the rear. The vast majority of funds are internally managed with only a small proportion of funds sub-advised by hedge fund managers. A greater level of convergence between boutique hedge fund managers and conventional fund manufacturers is expected going forward. We also expect to see foreign managers entering the Canadian marketplace.

Product Strategies Launched

Most of the products launched are equity focused mandates with alpha generating objectives to produce risk-adjusted returns that outperform benchmarks, followed by multi-strategy funds with absolute return objectives, according to a CIBC Report.  Fewer credit-focused strategies have been introduced, making it a potential growth area as more investors demand yield in a low-rate environment. The greater number of alpha strategies launched as compared to market neutral strategies is likely a result of restrictions on maximum shorting (50% of net asset value).[2] Liquid alts are in essence “hedge funds lite”- the short selling limit does not allow a pure long short market neutral strategy, the total leverage limit of 300% of NAV restricts some managed futures strategies, and the liquidity restriction of 10% of NAV precludes the offering of private debt funds. Investors would benefit from lifting of restrictions that preclude pure market neutral strategies and broadening of the types of strategies available in liquid alt vehicles.

Fees and Features of Products

Liquidity, hold periods and minimum subscription amounts are in line with traditional mutual funds. Low minimum investment amounts make the products broadly accessible to all investors, unlike exempt market hedge funds where minimums are much higher. Accredited investors may opt for liquid alt vehicles, even where exempt products offer additional features, to benefit from liquidity, transparency and better reporting.  Management fees are around the 1% range, also in line with mutual funds, and performance fees are in the 15% to 20% range. [3]In contrast to conventional mutual funds, liquid alts are permitted to charge incentive fees based on the performance of the fund, consistent with the typical compensation structure of private alternative funds. Fee models for liquid alt funds range from the standard perpetual high-water mark hedge fund fee model to fixed hurdle rates and relative benchmark models. There is a need for education on the role that performance fees play in aligning the interest of managers and investors as many advisers are uncomfortable with performance fees.

Challenges for Hedge Fund Managers

We will see an evolution of the space with growth and diversification in the number and type of investment strategies. All of which will bring new challenges of distribution and market saturation and may lead to the erosion of private hedge fund sales in Canada. The results of an AIMA Scotia Survey[4] found that 81% of advisers prefer liquid alt structures, we could see advisors opting for the enhanced liquidity and ease of entry (with less burdensome paperwork) of liquid alt structures over private funds. Hedge fund managers who were able to adapt existing strategies to fit the new rules have been able to expand their distribution channel to the retail world. To successfully launch a liquid alt fund, managers used to operating in the private hedge fund space, will need to adhere to more frequent and regular reporting and overcome operational and distribution challenges. Accessing the retail distribution channel continues to be a challenge for boutique hedge fund managers due to promotion of internal funds at large dealers and the declining number of new products being approved for distribution on bank-owned dealer shelves. If boutique managers cannot scale their operations, more convergence and consolidation can be expected.

Risk Ratings

It is imperative, especially late in the economic cycle, that Canadian investors have access to the benefits of alternative strategies and are not denied access by simplistic approaches that rate all alternatives as inherently high risk. Widespread adoption of liquid alts hinges on the assignment of fair and accurate risk ratings by dealers. All alternative funds, regardless of investment mandate, have historically been unfairly rated as high risk, limiting investors from accessing these strategies. Many dealers continue to label all liquid alts as high risk, particularly in the absence of 3-year track records. While risk ratings continue to a be a barrier to broad distribution of liquid alts, we are seeing some positive traction with dealers changing their approach to risk rating by adopting the AIMA / CAIA Risk Rating Guideline, introduced in 2019 to ensure investors have more fair access to alternatives.[5] Distribution channels will expand as dealers more broadly implement fair risk ratings and funds build a multi-year performance history that gives dealers justification to not label all alternatives with a blanket high-risk rating. The notion that all alternatives are high risk investments must be dispelled and replaced with information about how alternatives can reduce portfolio risk. This will allow dealers to allocate alternatives to an investor’s portfolio without using up the typical 10% investor high risk allocation bucket which advisers generally reserve for high risk-reward return investments.

Proficiency Requirements

Another barrier to distribution of liquid alts is the proficiency requirements under the new framework which retained standards for mutual fund dealers distributing commodity pools. MFDA dealers cannot sell liquid alts because they do not meet the requirements. Until suitable proficiency standards are adopted and dealers meet these standards many Canadians will continue to not have access to these products. AIMA is working with the MFDA and the OSC to solve this issue.

Market Environment

In this late-cycle as we head into a more challenging market environment with global quantitative tightening, trade wars and escalating macro-economic concerns, investors need to prepare for volatility of equity markets and declining fixed income returns by turning to investment strategies that are less correlated to traditional markets to preserve and grow wealth while effectively managing risk. Investors can no longer rely on the traditional 60/40 model. The long bull market allowed investors to be complacent, something they can no longer afford to do. A market environment with low or negative equity market returns will bring into sharper focus the benefits of alternatives as both defensive and offensive solutions. History has proven that unlike public markets, alternatives have delivered returns in both positive and negative economic conditions. With the advent of liquid alts, investors are now better able to achieve their financial goals by building a balanced portfolio that preserves capital and protects against downside risk to deliver risk adjusted returns.

Strategies for Late-Cycle Investing

The landmark change introducing the liquid alt regime came at a time when investors are looking for ways to protect against downside risk through uncorrelated returns while also generating attractive returns. Interest in sources of uncorrelated returns will heighten as market conditions worsen. Alternatives act as a diversifying tool to reduce volatility by generating returns with no or low correlation to traditional markets. Products that can preserve capital and enhance yield will be instrumental in a low rate environment, particularly with the aging demographic in Canada. Alternatives are a good fit for a long-term strategy because of their capacity to match long-term liabilities. Products that offer diversification from interest rate sensitivities are anticipated to multiply. Market volatility will create opportunities for tactical strategies that exploit market inefficiencies, such as short-term statistical arbitrage and factoring. Relative value strategies are also designed to perform in uncertain market conditions. Managers with a demonstrated track record successfully navigating through economic cycles will have an advantage. Negative market cycles have taught investors the value of defensive strategies that cushion portfolios against downside risk. The stage is set for alternative assets to play a dominant role.

Direction and Non-Directional Strategies

Strategies can be directional or non-directional to broad market movements. Directional strategies seek outperformance by amplifying returns through timing or shorting. Even strategies with underlying exposure to equities (e.g. market neutral) deliver returns that are independent of market movements. Performance of absolute return liquid alt funds in the 6-8% range annualized with volatility akin to bonds and low correlation to stock and bond markets is a good example of liquid alts functioning as designed. [6] Returns of equity and income alpha funds that reduce risk through low correlation to long-only indexes will naturally not be as strong as conventional long only funds in bull market years, but investors gain hedging protection. Non-directional strategies unlock value in pricing or idiosyncratic assets. Investors who want no underlying exposure to equities can opt for these alternative beta products (e.g. credit arbitrage, relative value, commodities, currencies, private credit, real estate, infrastructure, idiosyncratic strategies/assets.)

Portfolio Allocation with Right Mix of Alternatives

As we near the end of a decade-long bull market, a pivot to the right mix of alternatives in a diversified portfolio can provide retail investors with both resilience and returns. Greater diversification across all alternative asset classes is a trend to watch out for. Strategic asset allocation is fundamental to alternatives achieving their desired result. Disciplined allocation will empower investors to target desired returns, reduce risk and manage liquidity to meet their investment needs. There is a broad universe of alternative strategies across a spectrum of risk return profiles with unique characteristics and exposures to different types of assets. A real understanding of the strategies available and the trade-offs between them is needed to tailor allocation to investment objectives.

Alternatives can be used to enhance return, diversify risk, or provide outcomes such as inflation hedging, liability matching and cash flow generation. It is important for investors to understand both the benefits and risks of alternatives and how they differ from conventional mutual funds. Risk tolerance, liquidity constraints and time horizon will dictate how much of an investor’s portfolio is allocated to alternatives. A global survey by Preqin[7] found that 35% of advisors invest in liquid alts and another 16% plan to in the future. Advisers predict that close to 10% of their book will be allocated to liquid alts. A new model for portfolio construction, with a shift from the traditional 60/40 model, is expected to emerge for with alternatives making up between 5-10% of retail investor portfolios.

Future of Liquid Alts in Canada

We are still in very early stages of the liquid alts story in Canada. This is an unprecedented time of innovation and opportunity for Canada’s investment management industry. The space has a lot of runway to grow with alternatives expected to become a more favoured strategy as we head into a downturn and investors increasingly see the value of the asset class. Fuelled by a need to shelter capital and a demand for yield, the global alternative market is expected to hit $ 14 trillion (USD) by 2023[8]. The Canadian liquid alt market is forecasted to be a $20 billion to $100 billion market by 2025[9] – a meaningful share of the $1.5 trillion mutual fund market in Canada.

The fund-of-funds market is over $550 billion.[10] Greater take-up by fund-of-fund solutions, which can now invest up to 10% in liquid alt funds, has the potential to significantly accelerate growth of the market. More ETF launches are anticipated which will serve to increase the accessibility of alternative strategies and spur growth of the liquid alt sector, as seen with the ETF mutual fund experience in recent years.

Alternatives are increasingly becoming a mainstream integral part of institutional investor portfolios with allocations making up between 30%[11] to 50%[12] of portfolios and rising across a broader investor base.  Alternatives continue to gain momentum in the institutional arena with more than half of institutional investors planning to increase allocations over the next year.[13] We can expect to see this trend carry into the retail space and the products to become more mainstream catering to a wider investor demographic as liquid alt distribution channels widen with changes to risk rating models and opening of the MFDA sales channel of over 80,000 advisers.

Popularity of liquid alts will gain traction as the dealer community and the investing public become more familiar with the complexities of alternatives and how to assess products. Liquid alt sales are expected to ramp up once there are proven fund track records for advisors to point to and they become more attune to the compelling investment case and how to best allocate to alternatives as part of a balanced portfolio.

The regulatory sentiment also supports growth of the industry with short sale collateral limit relief, exemptive relief applications granted by the OSC, and a willingness to work with the industry to address proficiency requirements to allow MFDA dealers to distribute liquid alts. The liquid alt regulatory framework will continue to evolve over the next several years as regulators and the industry gain more experience in this area. AIMA Canada will continue to advocate on behalf of the Canadian alternative mutual industry for a flexible regulatory framework that will promote innovation and growth to provide Canadian investors with a suite of investment products that will help them realize their investment goals.