Hedge maze
Przemysław Ceglarek / 123RF

Volatile markets and low interest rates have been the bane of advisors in recent years. In such an environment, “you start looking for different return streams,” says Craig Machel, director of wealth management and a portfolio manager at Richardson GMP in Toronto.

And, with CSA set to release an alternative funds proposal for retail investors, alternative funds may now be more widely available.

Opportunity or hazard?

Machel is excited about the proposal. He says non-accredited investors “have been limited to big-box mutual funds and ETFs and exceptionally market-sensitive funds. […] Now the regulators […] want to provide everyone with a means to [non-correlated returns]”.

He describes alternative investments — hedge funds, private equity, long/short credit and more — as a huge world of opportunity, albeit one that requires education. “It’s […] a learning curve for advisors and for clients who’ve never been part of this world.”

Therein lies concern for Neil Gross, executive director of the Canadian Foundation for the Advancement of Investor Rights. He says the average investor can’t fully grasp the risks associated with alternative investments because, as most studies show, financial literacy levels in Canada are low.

“A product the client can’t understand is, for that client, inherently speculative,” says Gross.

Read: How transparency demand is affecting hedge fund managers

But James Burron, COO of the Alternative Investment Management Association, compares alternative investments to a product advisors and clients already understand: mutual funds. He recalls the increased demand for mutual funds in the ’90s, when “GIC refugees” went looking for higher returns after rates dropped. Advisors had to educate both themselves and clients, as well as manage client expectations. That experience will come in handy.

“Advisors already […] know what a mutual fund is. That’s good, because [alternative investments] are basically mutual funds [in the sense that] there [are] no [return] guarantees,” says Burron.

Similarly, advisors’ experience with long-only strategies can be applied to alternative strategies. In the long-only space, advisors know “how [different strategies] react in different markets and the degree of skill that’s required and the volatility of the strategies. […] The same [things] apply to hedge funds or alternative funds,” he says.

Gross says regulators erroneously rely on disclosure as a quick fix for conflicts and risks. “People glaze over or are induced to believe the disclosure’s boilerplate,” he says, adding he supports an enforced best interest duty for advisors.

Read: IIROC wants ‘strong, principled’ position on best interest

Proceed with caution

Machel, who creates portfolios made of 60% to 70% alternative investments, suggests a conservative approach to gradually acclimatize clients to alternative returns — a long/short equity fund, for example, or a long/short credit or bond fund to eliminate rate risk.

Managing volatility typically means clients lose less money and can subsequently make better decisions. “When we build these portfolios,” says Machel, “it starts with [assessing] what volatility on a short-term basis you can handle […] before you start panicking. We build out around that. […] It’s very reassuring for clients.”

Gross says alternative investments like hedge funds have high fees and must outperform the market considerably to match the net performance of a simpler low-cost ETF. The typical retail investor doesn’t want to be a speculator, he says.

But, says Burron, “If you’re buying stock, that’s always speculating.” Meanwhile, a portfolio with 10 to 50 positions in alternative investments would likely have non-correlated returns and thus minimize market volatility.

Steady, predictable, repeatable returns — regardless of what the markets are doing — are key, adds Machel.

Read: Should you stay benchmarked to the market?

Burron compares the fees to those of mutual funds, saying people are willing to pay more for professionally managed funds to get greater returns — or different returns, in the case of alternative funds. If returns aren’t different, don’t bother.

“If you don’t have lower risk or higher returns or better correlation, there’s no sense in doing any strategy,” says Burron.

Do the work

Machel says advisors must understand “what the fund is meant to do and […] what it can do in a worst-case scenario.” He asks managers, What’s the fund’s kryptonite?

“As advisors, we need to do a lot of work [to understand the process and people behind a fund …]. It’s not just a matter of looking at a return profile historically; it’s a matter of how those returns came to light,” says Machel.

The main risk is execution risk, he says. Are fund managers doing what they’ve been asked to do or are they exhibiting style drift?

It’s similar to mutual fund management, says Burron. “If two value managers are widely out of sync, you have to ask […] why.”

Read: Alternative managers pitch their best ideas

Not only are alternate investments great tools to serve clients in down markets, says Burron, they’re also a way for advisors to differentiate themselves.

“Advisors figured out mutual funds because they were incentivized — they made more money at it,” he says. “They won’t make any more money with hedge funds, but what they’ll get is something that can do well in a market downturn. They can be a bit of a hero to their clients.”