An in-depth look at liquid alts

Liquid alternatives, or liquid alts, made their Canadian debut one year ago, with the launch Mackenzie’s Multi-Strategy Absolute Return Fund. Since then, the category has grown explosively, with more than 30, each with its own unique flavour. At Mackenzie’s, liquid alt assets under management “already stand above one billion dollars” across four funds, claims Michael Schnitman, senior vice-president and head of products at Mackenzie Investments.

The whole space can be divided into five strategies, according to Edmund Fernandez, senior product analyst at IA Securities. There is the long/short equity stance, where the portfolio manager invests long in certain stocks and shorts a certain number of other stocks. The balance between long and short can vary widely according to market conditions.

Then comes the market neutral approach, very close to the preceding one except that long and short equities are calibrated in a way to reach a net exposure as close to zero as possible. These two are the classic hedge fund strategies that strive for a minimal correlation with prevalent equity markets. However, one must remember what a specialist once pointed out: “A perfect hedge exists only in Japanese gardens”.

One variant of the long/short stance is “alternative income” which applies to fixed income the practice of short selling and that may call on financial derivatives. An older variation of hedge funds concentrates long investment in an “alternative” asset sector, like real estate or infrastructure.

Finally come multi-asset strategies that go long and short in a large variety of asset classes: equities, fixed income, currencies, commodities, precious metals, agriculture, etc.

Common features

One strand runs through all these strategies: the use of leverage. However, where classic hedge funds could lever up to 10 times and more of their capital base, liquid alt funds are limited to a multiple of three times leverage. Though they don’t serve to define the category, other features often appear: highly concentrated asset allocations, a pursuit of absolute returns compared to a basic cash portfolio rather than returns related to current stock or bond benchmarks, the use of options and derivatives, and the possible presence of illiquid assets, notably direct investments in real estate and infrastructure projects.

Such a mix of components can make an unstable cocktail, especially the ingredient of leverage. This can be seen in the wide variety of year-to-date returns of the liquid alt funds included in the Scotiabank Alternative Mutual Fund Index. The S&P/TSX Composite index has returned 13.72% so far, year-to-date as of May 31st, according to Morningstar Direct data.

Source: Morningstar Direct data as of 05-31-2019

But the mix generally receives a low/medium or medium risk rating because these strategies aim at “reducing market volatility and generating a better return over a market cycle”, explains Schnitman. In general, “liquid alts don’t strive for the highest performance in a bull market and try minimise loss in a bear market,” says Francis Sabourin, manager, wealth management and portfolio manager at Richardson GMP. “They seek to be solutions for sunny days and rainy days as well.”

For a conservative investor, Fernandez would allot 5% to 10% of his portfolio to liquid alts. Around a core of equity mutual funds, he would reserve a portion for a market neutral fund, for example, that would mostly contribute downside protection to the equity base. He would also “put in a bit of fixed income liquid alts that can at the same time increase yield and lower volatility”. For a growth investor, “the allocation could go up to 20% of the portfolio,” Fernandez proposes.

Fine tuning required

An investor must be aware that pouring liquid alts into a portfolio “requires an increased attention to fine tuning,” Fernandez insists. “You can’t just throw in liquid alts; you need to take into consideration where the portfolio base lies.” For example, if an investor builds an equity base around a few equity mutual funds, he should make sure that any market neutral liquid alt offers exposure to equities different from the ones present in his mutual funds. Otherwise, the portfolio would be lopsided and the liquid alt would not perform as good a job at resisting market downturns.

Sabourin, who is actively developing liquid alt portfolios for his clients, proposes a 3-point list of advice:

1) Determine what you aim for: revenue increase or stability, lower volatility, return boost

2) Find the liquid alts that meet those objectives

3) Keep only the serious suppliers and filter out the opportunists who are only trying to dip into a passing fad.

Fernandez adds a 5-point check list for investors:

1)   How much leverage does a liquid alt fund call on, and what is the limit you are comfortable with?

2)   How concentrated is the portfolio? A more concentrated allocation can generate higher returns than a more diluted one, but also increases risk

3)   What is the underlying strategy, and how does it fit with your goals?

4)   What asset classes does the fund invest in?

5)   How liquid are they? Can you live with an investment in which you can pull out money only weekly or monthly?