Liquid alternative funds were tested during the market sell-off in February and March, with some providing the downside protection their proponents have insisted would eventually pay off.
Liquid alts — mutual funds that use alternative strategies such as short-selling, leveraging and derivatives — started the year as an asset class in need of a downturn. They became available to retail investors at the start of 2019, just in time for a banner year in equity markets that saw the S&P 500 gain almost 29% and the S&P/TSX composite end the year 19% higher. The Scotiabank Alternative Mutual Fund Index, by contrast, gained just over 5% last year.
The stock market fallout from the Covid-19 pandemic provided a chance for liquid alt managers — whose funds charge an average performance fee of 8% — to prove their worth. Many have.
“When the stock markets came down, they performed as they’re designed to,” said Barry McInerney, president and CEO of Mackenzie Investments. “[That’s] contrary to last year, when the markets went up, [and] these products didn’t go up in lock-step because they’re designed not to. They’re designed to be a diversified offset.”
In March, when the S&P 500 dropped 12.5% and the S&P/TSX composite fell by almost 18%, the Scotiabank Alternative Mutual Fund Index was down 6.6%. For the year as of May 30, the alts index is down 2.8%, compared to almost 6% for the S&P 500 and 11% for the S&P/TSX composite.
But measuring liquid alt performance as a group doesn’t capture the range in strategies or in managers’ abilities, said David De Pastena, vice-president for national accounts and portfolio solutions at Dynamic Funds.
“The problem is that in the liquid alts world, much like the hedge fund world or non-traditional asset classes, there’s a huge difference in returns from the first quartile to the bottom quartile,” he said.
Only about one-quarter of liquid alt funds are positive for the year to date, he said. Most of these funds have the ability to remove equity correlation by shorting stocks.
Within Dynamic’s products, for example, the Dynamic Alpha Performance II Fund, which uses long-short equity strategies, gained 5.9% this year to April 30; the Dynamic Real Estate & Infrastructure Income II Fund was down 22% over the same period.
The AGFiQ U.S. Market Neutral Anti-Beta Fund, which has a negative correlation to the market, soared from late February to mid-March and was up about 20% for the year at one point, said AGF Investments chief investment officer Bill DeRoche, who’s head of AGFiQ alternative strategies.
“It’s given a significant amount of that back, but it’s doing exactly what we would hope it would, which is to mitigate that volatility so, at the end of the day, your cumulative wealth is not being so negatively affected,” he said.
The fund was up about 1.4% for the year as of June 4, according to Bloomberg data.
In addition to the track record certain funds can now point to during the sell-off, the fixed income outlook could also provide an opportunity for liquid alts going forward. With interest rates near zero, investors may be looking for other solutions for income and downside protection.
As yields drop, investors look for longer duration, DeRoche said, “so your risk-mitigating asset class now has lower return expectations and higher risk associated with it.”
There’s a case for giving products that hedge equities a higher portfolio allocation in a low-rate environment, he said.
As markets rebound, investors recovering from the shock may also be seeking diversification, said Mark Brisley, managing director at Dynamic Funds.
“Downside protection has become a huge part of the alternative discussion,” he said.
With interest rates so low, alternatives could be an option for retirees seeking 3% or 4% income, De Pastena added.
But as a recent guidance from the Investment Industry Regulatory Organization of Canada highlights, products using leverage and inverse strategies can be especially risky in volatile markets.
Advisors need to make sure they’re dealing with managers with proven track records, De Pastena said. Liquid alts “are the equivalent of weapons of mass destruction because of the ability to leverage and short and so forth.”