Hedge maze
Przemysław Ceglarek / 123RF

Once only available to institutional investors, retail investors have had access to liquid alternatives since the start of this year, thanks to the Canadian Securities Administrators’ new rules.

Known as liquid alts, the funds use alternative strategies such as shorting, leveraging and derivatives.

But confusion around these investments still exists. Before adding liquid alts to a client’s portfolio, it’s important to understand how these investments can add value.

The new rules “allow Canadians that have been shut out of the hedge fund marketplace because of either small savings amounts or other risk-related issues to now be able to participate in these spaces,” said David Picton, president and CEO at Picton Mahoney Asset Management in a Feb. 21 interview.

“We think this is an amazing opportunity from a portfolio construction point of view,” he said. “You want to use alternative strategies as ways to meet your long-term savings goals with more certainty along the way.”

The U.S. modernized its fund regulations in 2013, propelling liquid alts’ assets under management to approximately US$225 billion by 2017, a recent Scotiabank report said. Based on the size of the Canadian market, liquid alts could grow to more than $20 billion in five years.

Industry analysts have suggested potential market penetration ranging from $15 billion to more than $100 billion, according to the report.

The greatest challenge facing the industry is understanding how these new products fit into portfolios and improve the quality of returns, Picton said.

“What we’re trying to do is build a portfolio construction framework that allows you to take your traditional 60% equity, 40% bond mix and not replace it, but rather augment it by adding in some of these new liquid alternative strategies,” said Picton.

That could mean risk-premium strategies, like momentum or deep value, and alpha-based strategies, such as market-neutral funds or long-short funds.

“That sounds confusing,” Picton said. “So the key is to understand what your stock-bond mix is.”

The 60/40 model has been “unbelievably good” over the last number of years but will run into pressures in a rising rate or rising inflation environment, he said.

That’s why investors may want to augment that 60/40 mix “with things that actually make you a little bit different and enhance your return potential while reducing risk potential,” he said. “Or, at least, for the same level of risk that you’re willing to take in your portfolio, deliver a higher quality return stream that goes with it.”