The Alts Are Coming, The Alts Are Coming.

The ever-innovative investment fund industry has given us Return of Capital mutual funds, Leveraged Exchange-Traded Funds (ETF)’s, the Deferred Sales Charges (DSC) mutual fund and the unforgettable Labour-Sponsored Investment Fund. As to the core business, actively-managed mutual funds, the latest SPIVA Report (https://us.spindices.com/documents/spiva/spiva-canada-scorecard-year-end-2018.pdf?force_download=true) paints a gloomy picture of active management. The majority of funds in virtually every category could not match a passive index. The latest “innovation” is the alternative mutual fund. Alt funds (aka liquid Alt funds) use alternative strategies to optimize returns for investors while providing downside protection in falling markets.

The Canadian Securities Administrators (CSA) Final Rules became effective on January 3, 2019 and modify provisions in National Instrument 81-102 Investment Funds (“NI 81-102”) and related National Instruments that previously applied to conventional mutual funds and non-redeemable investment funds. https://www.osc.gov.on.ca/en/SecuritiesLaw_csa_20181004_81-102_alternative-mutual-funds.htm#4140s2annc1. Under the final rules, alternative mutual funds will be able to distribute their securities on a continuous basis to retail investors under a Simplified Prospectus in essentially the same manner as conventional mutual funds. Some Alts may come in ETF format. The Desjardins Alt Long/Short Equity Market Neutral ETF (DANC) has been trading on the TSX since January with a one per cent management fee.

Alternative funds historically have used non-traditional investment strategies. In contrast to traditional mutual funds, which are more diversified and take long-only positions in publicly traded securities, with daily liquidity, alternative funds have been considered unsuitable for retail investors. Alternative funds have been utilized by large institutional investors who do not need immediate liquidity and have been available to “accredited investors” (high net worth clients with incomes of more than $200,000 a year or a net worth of $1 million.) who are deemed to have access to professional advice as well as the capacity to tolerate loss.

The introduction of liquid Alts into the retail investor market is a boon for mutual fund manufacturers and will provide an opportunity to drive new sales to retail investors. In the U.S., the liquid Alt market has grown to more than US$225 billion in assets under management since Securities Exchange Commission (SEC) mutual fund regulations were amended in 2013. Based on the U.S. case study, and the ten to one ratio of the U.S. market’s size to Canada, the liquid Alts market could grow to more than C$20 billion in five years according to a Scotiabank study. It comes at the right time as fierce competition, ETFs and robo advisors reduce margins. Investors should brace themselves for aggressive sales pitches.

In light of the significant problems with the existing relationship between dealers and their individual registrants with their clients that have been highlighted by investor advocates and acknowledged by the CSA (Consultation Paper 33-404), investor advocates called on securities regulators to not increase the ability of dealers to sell complex products to their retail clients until a statutory best interest standard is implemented. It was argued that a retail investor should not be sold an alternative fund unless the dealer and the individual registrant do so on the basis that it is in the best interest of the investor.

Industry proponents claimed the change is significant in that it really is the democratization of risk-managed hedge fund strategies while investor advocates feared increased complexity, confusion, risks and costs.

The present securities regulatory framework does not provide adequate investor protection for mainstream products such as mutual funds, let alone complex products such as alternative funds. The advocacy arguments were nevertheless rejected by regulators who approved the sale of Alt funds to retail investors, albeit with several constraints.

This category of investment funds will be known as “alternative mutual funds” and defined as: “a mutual fund, other than a precious metals fund, that has adopted fundamental investment objectives that permit it to invest in physical commodities or specified derivatives, to borrow cash or engage in short selling in a manner not permitted for other mutual funds”. Interestingly, the final amendments include a new feature allowing Alt funds to enter into derivatives with counterparties who do not have a designated rating.

Alternative mutual funds and non-redeemable investment funds will be permitted to borrow from both domestic and foreign entities that qualify as custodian or a sub-custodian under NI 81-102. The overall leverage limit for alternative mutual funds will remain at 300% of Net Asset Value (NAV) but the calculation of leverage will exclude the notional value of derivatives used for “hedging” purposes. Alternative mutual funds and non-redeemable investment funds will be permitted to deposit portfolio assets with a value of up to 25% of NAV with a single borrowing agent (other than the custodian or a sub-custodian of the fund) as collateral for short sale transactions. While fund purity would be impacted, alternative funds manufacturers will benefit from conventional funds being able to invest up to 10% of their NAV in Alt funds.

Investments by alternative mutual funds in any one issuer can be no more than 20% of NAV of the fund at the time of purchase (in comparison to 10% for conventional mutual funds). Alternative mutual funds are exempt from any restrictions relating to investments in physical commodities under the “final rules”. Further, conventional mutual funds, which were primarily restricted to investing in gold, are now permitted to invest (directly or indirectly through specified derivatives) in gold, silver, palladium and platinum subject to an overall limit 10% of NAV. Unlike conventional mutual funds, which may only charge incentive fees calculated in relation to a reference benchmark or index, Alt funds may be charged performance fees based solely on a high-water mark (e.g. no need to outperform an index). Expect Alts to make maximum use of that latitude.

The new regime will allow Alt funds to be sold by Registered Representatives regulated by the Investment Industry Regulatory Organization of Canada (IIROC) with no additional requirements. Mutual fund licensed salespersons, however, will need to have additional proficiency requirements in order to sell them. A fund facts document will be prepared for these funds similar to that employed by conventional mutual funds (Sample fund facts document: Note the low to medium risk rating, a 0.50% trailing commission and the rather complex calculation of an annual performance fee http://ci.com/web/fundfa%cts/CIG2190_EN.pdf )

Investor advocates were very disappointed with the CSA’s final rule on how risk will be described in the fund facts document. There was an expectation that the fund facts document would supplement the scale of risk (that classifies its standard deviation) with a narrative description of the limitations and explain the other risks not covered by the five element text-based scale (such as counterparty risk). European regulators decided that while “a scale may be considered appropriate”, it also determined that in order for “regulators and investors need to be aware of the inherent limitations in such measures supplementing the scale with a narrative description of its limitations and the other risks not captured by the synthetic indicator was required”. Canadian regulators disagreed so investors will thus have to refer to the simplified prospectus if they want to know all the risks associated with an Alt fund (See sample Simplified Prospectus Mackenzie Alt funds: https://www.mackenzieinvestments.com/en/assets/documents/mutualfunds/prospectus-2019-jan31-en.pdf ).

Costs will be similar to mutual funds, or likely higher, but will vary considerably by category and as competition builds. Fund Facts will not disclose performance data or trading costs if the funds are less than one year old.

A Report, Liquid Alternatives: Alternative Enough? from the CFA Institute based on U.S. Alt funds had this to say: “Liquid alternatives are useful investment products that give all sorts of investors access to typical hedge fund strategies and exert pressure on the hedge fund industry to reduce its fees. But investors should be wary of liquid alternative funds that offer equity exposure at high fees and effectively represent fake alternatives.” https://blogs.cfainstitute.org/investor/2018/09/24/liquid-alternatives-alternative-enough/

According to a Morningstar research Report Liquid Alternatives Haven’t Lived Up to the Hype (Yet) most U.S. liquid alternative funds failed to improve a traditional stock and bond portfolio over the time periods studied, although market neutral funds had a decent showing over both time periods and non-traditional bonds look particularly useful over the more recent time frame. Indeed, it’s been a difficult period for most diversifying strategies, given the low volatility in equity markets as they’ve continued to march higher. .... Of course, this doesn’t mean that liquid alternatives can’t potentially help portfolios over the next three and five years. But so far, they haven’t been as helpful as many investors probably expected.” https://www.morningstar.com/blog/2018/08/02/liquid-alternatives.html

A Report from Nexus Investments, In Search Of Simplicity In investing, does complex really mean better? stated: “…As for the individual investor, indeed, some people are wired for risk. They like the thrilling prospect of extraordinary returns, and can stomach the roller coaster ride, lack of transparency, illiquidity and the higher fees often associated with more exotic investments. If an investor wants alternatives or the “flavour-of-the-month” product, there is no shortage of choice….” https://www.nexusinvestments.com/wp-content/uploads/2018/05/In-Search-of-Simplicity.pdf.

Investors should seriously consider if they want or need exposure to products they likely will not understand.

In early May, the Canadian Investment Funds Standards Committee (CIFSC) and the Alternative Investment Management Association in Canada (AIMA Canada) announced that the CIFSC is introducing a new approach to categorizing alternative funds that uses five separate groups, replacing the broad “alternative” category that was previously in use. The five new alternative categories are equity-focused, credit-focused, multi-strategy, market-neutral and other. They aim to help advisors and investors more easily compare funds and assess the performance of different alternative investing strategies.

When buying an Alt fund, be aware that in addition to the usual market and investment risks associated with traditional mutual funds, Alt funds may face additional risks to the extent they use relatively complex investment and trading strategies. Depending on the strategy being used, these potential risks can include use of derivatives and leverage, futures contacts, short selling and swaps. Alternative mutual funds may have higher expenses than their traditional mutual fund peers. The strategies pursued by Alt funds are often complex and require significant expertise and active management, which increases costs. In addition, the more complex strategies themselves may generate additional fund expenses. U.S. Alt funds were launched after the 2008 financial crisis, so it is not known how they would perform in a down market. Investors should try to learn as much as much as possible about the fund manager, such as his or her prior management or professional experience with alternative strategies.

In April 2019, Scotiabank launched an index for liquid Alts. The index consists of 22 funds launched under new rules effective since January. Returns will be calculated monthly. The index can be found here: https://www.gbm.scotiabank.com/content/dam/gbm/import/pdfs/prime-services/mutual-funds-index/Scotia-Alternative-Mutual-Fund-Index-March-2019.pdf

A huge challenge facing the advice industry is understanding how Alt funds fit into portfolios and improve the quality of returns. Advisors will need to know how to construct a portfolio framework that builds on the traditional 60% equity, 40% bond allocation by using some of these liquid alternative strategies. It remains to be seen how this will play out.

Ken Kivenko, PEng, President , Kenmar Associates, Etobicoke, ON (416) 244-5803, kenkiv@sympatico.ca, www.canadianfundwatch.com