The birth of Liquid Alts
Are they just watered-down hedge funds?
After years of consultation with investors, regulators, and advisors, the Canadian Security Administrators (the national association of security regulators) launched a new category of mutual funds in January – and they’re calling it Liquid Alternatives. (See John Krisko’s recent article on how this category is defined.)
A few companies like Mackenzie, Dynamic, and CI have jumped the gun and applied for and received exemptive relief, but those products are offered only by IIROC advisors. In January, the Liquid Alternative funds will be available to both IIROC advisors and MFDA advisors (mutual fund only) who have obtained the necessary accreditation.
A good way to look at the new Liquid Alternatives category is to think of it as “hedge fund lite.” The funds are allowed to use some of the strategies used by hedge funds but have very strict limits on how the portfolio is to be managed, including such things as limits on short selling, the use of leverage, and the use of private or illiquid investments.
For example, a fund may use leverage, but would be capped at three times net assets. A hedge fund, on the other hand, has no such regulatory restrictions in place. The new funds may also use short selling, but are limited to 50% of the NAV. The difference is that unlike the short selling that is allowed for traditional mutual funds, no cash cover is required.
The funds may also take more concentrated positions, and can invest up to 20% in one issue, compared with the current cap of 10%. And Liquid Alternative funds may also invest up to 10% in illiquid assets.
Funds may also be paid performance fees on positive performance. In theory, this is a great move for investors. By including an any fund that has a positive expected return and low or negative correlation to the other portfolio holdings will actually reduce risk and enhance return over the long term. In theory.
The challenge will come in the execution of these new funds. These funds are using strategies that until now have been off limits for most mutual fund managers. A great example is short selling. On the surface, this looks to be a “no brainer.” A fundamental manager finds a stock that is overvalued and shorts it. Unfortunately, it’s much more complicated than that, and there are a lot more moving parts to the practice of shorting.
First, the manager needs to “borrow” the stock that they will be able to sell into the marketplace. That is not always an easy task. Second, there is often a cost to borrow a stock. In some cases, the borrow will be cheap, and in other cases, it will be prohibitively expensive. The manager must weigh the cost of the borrow against the potential upside to determine whether it is worth it.
Typically a near-term catalyst is also required to be successful in shorting, and that may not be something a manager who has a history of running traditional long-only funds will be quickly able to identify.
There are potentially a lot of moving parts to these new funds, and it is imperative that the managers have a proven track record of running alternative strategy money. In other words, you can’t simply flip a switch and watch a great mutual fund manager become a great hedge fund manager. It may happen in a few cases, but more often than not, the results will be disappointing.
The due diligence and “know your product” obligations are significantly higher with Liquid Alternative funds, which is why there are higher professional requirements needed before an advisor can offer these funds to clients. Anyone offering these funds really needs to understand what they are, how they work, and fully understand the risks.
These funds also have the potential to be more expensive than traditional funds, particularly if there is a performance fee included. That’s fine if the manager has the potential to consistently add value over time, but if not, you’re stuck holding a very expensive, sub-par mutual fund.
Taking a very quick look at some of the Liquid Alt funds that have been brought to market so far, there hasn’t been much that has caught my eye. In my opinion, the best so far have been the systematic long/short funds brought to market by hedge fund manager Edgehill Partners. It will be very interesting to see how the new product launches begin to unfold in the New Year.
If the rollout of these new funds goes well, it will be a win for all parties involved. Investors will have another very strong tool to help them build better portfolios designed to withstand all market conditions. My fear, however, is that the products launched will be watered down versions of hedge funds or expensive levered long mutual funds and will be mis-marketed to investors with unrealistic claims of what these funds can do. Several years from now, we may look back at the Liquid Alt funds and see that this has been one giant failure. I am challenging the advisors and fund providers to prove me wrong.
Dave Paterson, CFA, is a money manager and an expert on investment fund research and due diligence on a variety of investment products.
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