Canadian regulators are in the midst of updating investment fund product regulations that could soon see adventuresome retail investors buying sophisticated liquid alternative investment funds for the first time.
Liquid alts, as they are more commonly known, employ strategies such as short-selling, borrowing and leveraging in traditional asset classes like stocks and bonds, as well as more non-traditional assets such as infrastructure and real estate. All of these are currently the purview of institutional and high net worth investors, but are considered too risky for retail investors and have not generally been allowed for mutual funds or exchange-traded funds (ETFs).
But should these liquid alts be approved by the Canadian Securities Administrators (CSA) – as many hope they will – they will offer up a new, more accessible product for the average investor, probably sometime in 2018.
The proposal is included in part of a CSA paper on the Modernization of Investment Fund Product Regulations, which is reviewing the parameters of product regulation that apply to investment funds.
“The Proposed Amendments, if adopted, are expected to have a meaningful impact on publicly offered mutual funds that utilize alternative strategies or invest in alternative asset classes (alternative funds) and would also affect other types of mutual funds (namely conventional mutual funds and ETFs) as well as non-redeemable investment funds,” states the paper.
The term “alternatives” is a bit of a catchall phrase and can incorporate anything outside the usual realm of stocks and bonds. Asset classes like REITs, bank loans and real return bonds are all considered liquid asset classes that are not mainstream and so are considered alternatives, says Stephen Leong, head of Canadian product for iShares at BlackRock. Infrastructure, physical real estate and some ETFs that invest in the equities of real estate companies, comprising a mixture of equity exposure and alternative asset class exposure, are also considered liquid, says Leong.
With all alternative products, investors are looking for a different return stream to the market than they already own through traditional asset classes like equities or fixed-income, says Christopher Doll, vice president at Invesco’s PowerShares sales and strategy. But traditional alternatives typically have been designed for well-heeled institutional investors who can go in and buy an airport, for example, or a building with commercial operations or apartments. Doll says the cost of a liquid alternative in ETF form would probably be in line with other ETFs.
In its paper, the CSA says that while some liquid alternative strategies may be riskier, many are also designed to lessen market risk and may also produce more consistent returns in certain market conditions. “We think that not proceeding with the Proposed Amendments would stifle innovation in the marketplace to the detriment of both investors and the investment funds industry.”
Doll, like others in the industry, is looking for a larger audience to take part in liquid alts. “As a firm we do have a strong belief that there is a place for liquid and traditional alternatives in a client’s portfolio. So from that perspective we have invested in building out our alternatives franchise here in Canada and around the world.”
PowerShares is new to the alternative space, especially on the ETF side, which Doll sees as a still-burgeoning space. “The accumulation of assets has been positive [but] I don’t think we’ve been blown away by it. If you look at the more traditional alternative space we have a much longer track record, much more established teams in that space that have produced quality results and accumulated a number of clients who have invested in our funds. So it’s tough to compare our recently launched ETFs on liquid alts to our longer term traditional alts,” says Doll.
Should the CSA come out in favour of liquid alts for retail investors, the average investor will still need a lot of education before investing in these products. “[But] I think you will find in the next few years that that’s going to become a growing segment within the industry,” says Leong.
Key to using liquid alternatives wisely is their understanding by advisors, who, for the most part, are just becoming aware of the proposed rules themselves, says Leong. As long as the advisor understands what role a particular strategy is playing – whether as a diversifier, a risk mitigation tool, or as an uncorrelated strategy – there’s no reason why they can’t be appropriately incorporated into a retail portfolio, says Leong.
Jurisdictions outside of Canada have moved a little bit faster in creating a framework for retail use of liquid alts. BlackRock, a large manager of liquid alternatives outside of Canada, has definitely seen the difference. “We’ve seen pretty healthy adoption by advisors in the past five or six years as these rules have taken hold [outside the country], so it’s becoming more mainstream in other jurisdictions.”
Assets under management for liquid alts in the U.S. stood at about US $110 billion in early 2011, and now stand at more than US$224 billion, according to Morningstar data.
The rise in liquid alts in the U.S. stems from the steep declines in global equity returns during the financial crisis of 2007-2009. More recently, poor returns from global bond markets have piqued investor interest.
Products for high net worth clients
Some products similar to liquid alternative products, open to institutional and high net worth clients, are already in the Canadian market. Horizons ETF Management has a number of liquid alt products. Included is the Horizons Absolute Return Global Currency ETF, which uses derivatives to gain exposure to select global currency markets, the Horizons Morningstar Hedge Fund Index ETF, which is hedged to the Canadian dollar, as well as the Horizons Seasonal Rotation ETF, which uses various equities, fixed income, commodities and currencies during periods that have historically demonstrated seasonal trends.
Franklin Templeton Investments has its Franklin K2 Alternative Strategies Fund, a diversified portfolio of hedge strategies.