Why this product is generating so much buzz in the mutual fund industry

Canadian mutual-fund companies could soon be offering retail investors a category of complex investment strategies now reserved just for associations and high-net-worth individuals.

Regulatory approval for these so-called “liquid options” funds, which are intended to optimize yields while providing downside protection in falling markets, could come as soon as next year.

The stakes are high for a business being pummelled by an avalanche of investment dollars leaving managed funds in favour of cheap, passive indicator products. At present, alternative approaches in Canada are only available to institutional investors or high net worth customers with incomes of over $200,000 per year or a net worth of $1-million. If approved for retail investors, liquid options could have market potential of over $100-billion of assets under management (AUM) within a five-year interval, according to a recent CIBC analysis report.

“The arrival of liquid options is possibly the most exciting regulatory development for the Canadian mutual fund industry in a really long time,” Paul Holden, a research analyst with CIBC, said in the report. “It is very welcome at a time when international regulatory pressures are mounting and competition from low-cost passive plans has taken a bite out of adulthood.”

Liquid alternative funds — also called liquid alts — are typically hedge fund or private equity plans made accessible through a mutual fund accounts. The Canadian Securities Administrators published a proposal newspaper that was open for comment in 2016. The paper has been completed as part of a larger fund modernization project that commenced in 2012 and says the proposed changes will “help facilitate more alternative and innovative strategies while at the same time preserving restrictions that we believe to be appropriate for products that may be offered to retail investors{}”

The CSA is now reviewing the business comments and expects to release its final amendments following summer.

The CSA’s proposed changes are mostly directed at developing a broader regulatory framework for publicly offered alternative funding (now referred to as commodity pools). Additionally, the CSA would introduce or revise specific investment limitations for these funds, including concentration limits, limitations on illiquid assets and limitations on cash-borrowing, in addition to introduce disclosure requirements for other funds that would clearly highlight the investment plans that distinguish these products from traditional mutual funds.

“Many mutual fund companies are preparing product capabilities before the go-live date so as to be fast to market,” Mr. Holden says. ” [B]ecause of the market nature of specific investment plans and initial demand doubt, we wouldn’t be surprised to find a relatively substantial proportion of mutual fund businesses begin liquid options with hedge funds acting as sub-advisers.”

Firms like AGF, IGM Financial, CI Financial, Manulife Investments, Fidelity Investments Canada and Franklin Templeton are actively tracking the development of the alternative fund asset class.

“We’re looking at [alternatives funds] and see an opportunity for our supervisors to take part in that area,” states Steve Donald, executive vice-president of CI Financial.

Manulife Investments has alternative asset management capabilities, which are used in either a retail and institutional capacity outside Canada, but will wait to completely review the rules before creating any merchandise for Canadian retail investors, ” says Bernard Letendre, president of Manulife Investments.

“We consider alternatives can play an significant role in the portfolios of Canadians and we eagerly anticipate the final details of the regulatory framework,” says Mr. Letendre. “We’re optimistic that the new regulation provides more chances to match our existing mutual fund and ETF plans to enhance the probability of Canadian successfully achieving their investment objectives.”

The CSA has proposed investment parameters for other funds that would allow hedge-fund-like plans, but with restrictions to protect investors from excessive risk. Hedge funds are generally designed to provide investors with capital preservation and downside protection as yields are usually uncorrelated to equity and fixed income markets. Like a mutual fund, a hedge fund is a managed, pooled fund which uses different approaches to invest and may include leveraging, derivatives and short-selling.

The proposed parameters from the CSA would see alternate funds provided to retail investors which include more borrowing, shorting and derivatives strategies. At the same time, the proposed rules would also enable levered investment plans, similar to what’s currently available from the exchange-traded fund market. The recommended limits to the amount of borrowing and short-selling for these alternative approaches is 1 area industry commentators have been debating.

If provided to the retail investor area, the alternate fund arrangement combines the best of mutual funds with the best of private pools and hedge funds, says CIBC’s Mr. Holden.

“Liquid options combine the advantages of mutual funds, namely transparency and liquidity, with the advantages of private pools, namely investment flexibility,” he adds. “Investment flexibility in pools may provide access to higher return plans, but perhaps it’s the diversification benefits from uncorrelated plans that provide the significant utility for investors{}”

In the five years after the fiscal crisis, the U.S. liquid alts marketplace has risen to $218-billion (U.S.) in AUM, up from $83-billion.

In Canada, mutual fund provider Franklin Templeton Investments Corp. stepped to the liquid alt area last year with the launching of an alternative strategies fund for accredited investors. The Franklin K2 Alternative Strategies Fund allows accredited investors access to a diversified choice of institutional hedge fund managers and plans.

“We are very happy to open this fund to Canadians that are searching for an investment that could potentially reduce volatility in unpredictable markets, while providing the potential for appealing risk-adjusted returns,” stated Duane Green, president and CEO of Franklin Templeton Investments Corp. in Canada at the time of their launching.

The introduction of liquid alts into the retail investor could deliver diversification benefits to Canadians, says Mr. Holdensaid At the same time, the introduction of retail option funds is timely to the active management industry that’s facing pressures on multiple fronts, such as competition from passive plans — such as ETFs. Horizons ETF Management (Canada) Inc. has been supplying similar alternative approaches to retail ETF investors because 2009. The business has $267-million (Canadian) in AUM in five ETFs from the liquid alt space.

“We think there will always be a place for liquid options in retail customers’ portfolios, in addition to, hopefully, continue to maintain the ETF area,” states Steve Hawkins, president and co-CEO of Horizons ETFs. “The Canadian ETF market is progressing more and more every day and it is just a matter of time before these plans are mainstream one of ETF providers … [W]e are a strong supporter of liquid options from the beginning.” The products may also be deemed insecure — even though the CSA proposal points out that “many are also designed to mitigate market risk, take advantage of market inefficiencies or to help produce more consistent yields under different market conditions.”

Dan Hallett, a leader with High View Financial Group, says the introduction of alternative plans might be a fantastic addition to retail investors’ portfolios, in concept, but it may come with greater fees than anticipated. “The idea with hedge fund [plans], in part, isn’t to prevent risk but to isolate risk exposure,” Mr. Hallett says. “Therefore it does make sense to have exposure to more than one strategy, but the issue with some of the fund of fund structures found in these plans is the double-whammy of opaqueness and many layers of fees{}”

The complex layers of liquid alternative approaches may pose a problem for the advisor community as regulators are considering whether mutual fund advisers should be required to acquire additional competency requirements specific to alternative funds before being able to market these products.

While the independent finance companies will be set to establish if the green light is given, analysts forecast the banks won’t be early adopters of the product, instead will track the progression of the liquid alt market carefully from the sidelines.

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ALTERNATIVE OPTIONS

Canada’s securities regulators are looking at opening the door for mass retail investors into the liquid-alternative-fund marketplace in 2018, but for investors looking to tap into comparable hedge-fund-like strategies before then, which could provide downside protection in the event of a market decline, here are four options to consider:

Manulife Investments

Manulife’s Global Total Return Strategies seeks to provide positive absolute returns over the medium to long term, whether markets are rising or falling. Available from Manulife as a segregated fund or — for qualified investors — a personal mutual fund, both invest in the underlying GARS investment plan managed by Standard Life Investments Ltd. (which invests primarily in a combination of derivative contracts, equities, fixed-income securities and money on the international markets). The management-expense ratio for the segregated-fund alternative is 2.93 percent, and 2.62 percent for the adviser set of the personal mutual fund.

Franklin Templeton

Franklin Templeton entered the alternative-fund distance last fall when it established the Franklin K2 Alternative Strategies Fund. The actively managed fund is currently only available to licensed retail and institutional investors in Canada and has a management fee of 1.9 percent (for the O series fund). Managed by portfolio managers David Saunders, Brooks Ritchey and Robert Christian, the fund’s principal investment goal is capital appreciation with reduced volatility relative to the broad equity markets. To attain that goal, the fund allocates its resources across multiple choice hedging strategies, including long/short equity, relative price, global macro and event-driven.

Horizons ETFs Management (Canada) Inc..

Sub-advised by CIBC Asset Management Inc., and with a management fee of 0.95 percent, the Horizon Total Yield Global Money ETF uses money instead strategy for investors. Historically, a diversified basket of international currencies has a low correlation to stocks and bonds. Together with the ticker HARC, the fund attempts to create positive absolute returns through short and long exposure to selected global currencies and normally holds Canadian short term fixed-income securities using derivative instruments to gain its vulnerability to selected global currencies.

Purpose Investments

The Purpose Multi-Strategy Market Neutral fund utilizes classic hedge-fund investment strategies like long/short equity, momentum and carry themes within commodities and currencies. Purpose provides both ETF and mutual fund classes of this fund, which has a management fee of 0.95 percent. With the ETF ticker PMM, the finance uses equity, commodity and currency exposures offering little to no significance to the capital markets. The fund may also provide investors with a low correlation to other assets and possibly higher risk-adjusted yields, while utilizing less leverage relative to other long/short finance strategies.

Courtesy: The Globe And Mail

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