Hedge maze
Przemysław Ceglarek / 123RF

Advisors looking to maintain returns on the fixed-income side of clients’ portfolios may want to consider liquid alternatives, but understanding these new products’ strategies is crucial.

Liquid alternatives — which use hedge fund strategies such as long-short, market neutral and derivatives — became available to retail investors in Canada in January 2019.

For advisors worried about generating sufficient fixed-income returns, liquid alternatives (which are offered as mutual funds and ETFs) are a possible solution, panellists at the annual Inside ETFs Canada conference — being held virtually this year — said on Tuesday.

With interest rates near zero, traditional bond holdings provide little ballast during market turmoil while offering virtually nothing in the way of yield.

“We have to face this dilemma,” said Francis Sabourin, portfolio manager and director of wealth management at Richardson GMP in Montreal.

The odds of a traditional 60-40 portfolio meeting clients’ return targets are “extremely low,” said Marc-André Gaudreau, vice-president and senior portfolio manager at 1832 Asset Management in Montreal.

Advisors can increase the equity weighting in portfolios, Sabourin said, or “play in the high-yield space or the corporate space and go way out of the comfort zone of some clients in terms of fixed income.”

Sabourin and Gaudreau both favour using alternative strategies on the fixed-income side of a portfolio — particularly long-short credit products that provide uncorrelated returns without sacrificing a portfolio’s overall return.

After almost two years in market, there are now 106 liquid alternative funds in Canada from 38 issuers, with $10.6 billion in assets under management, said moderator Shana Sissel, chief investment officer at Chicago-based Spotlight Asset Group.

The strategies employed by these funds can be wildly different, as performance during the market sell-off in March demonstrated. Certain market-neutral funds soared during the turmoil, while some real estate funds fared much worse than the overall market.

At the end of October, the Scotiabank alternative mutual fund index was basically flat for the year, while the S&P/TSX 60 was down 8.69%. The S&P 500 had returned 1.21% over the same period.

Sabourin said it’s especially important for advisors to understand the liquid alternative products they’re recommending and how the funds are expected to behave in different market environments. This can be difficult in a universe with “a lot of newcomers” that don’t have track records, but he said it’s up to advisors to understand the investment process and explain it to clients.

“In March there were some people who were very upset when they saw the returns of their liquid alt or alt strategy,” Sabourin said. “At the end of the day, it’s tougher for clients to understand, and for advisors, it’s tougher to track.”

The market sell-off earlier this year may be helpful for advisors looking for a track record of how products behave in periods of extremely volatility, Gaudreau said.

Advisors also face the challenge of fitting products into portfolios while complying with clients’ investment policies. Some market-neutral products behave like fixed income, with low volatility and expected returns of 3% to 5%, Sabourin said. But compliance departments classify them as equity products.

“This is one of the biggest challenges we face,” said Sabourin, who uses alternatives as fixed income replacement but not on the equity side. “We would like to use more of these liquid alts — market neutral or long-short equity — but they are part of the equity bucket.”

A report earlier this year from Boston-based research firm Cerulli Associates noted the challenges liquid alternative manufacturers in the U.S. market face in explaining complex products to advisors. The report said manufacturers should develop less expensive products that are easier to explain, taking a page from “the passive management playbook.”

Editor’s note: Advisor’s Edge and Investment Executive are media sponsors for this year’s Inside ETFs Canada event. This story was written independent of the sponsorship.