What’s coming next: mutual funds with hedging powers
Alternative mutual funds known as ‘liquid alts’ have caught on like wildfire south of the border
By: DIANNE MALEY
Date: October 13, 2015
Som Seif sees a day when hedging strategies are no longer a separate asset class but part of every fund and portfolio in the country, large or small. Mr. Seif is founder and chief executive officer of the fund firm Purpose Investments Inc. in Toronto.
Investors will need alternatives to traditional stock and bond portfolios in the future because bonds won’t be the buffer against falling stock prices they once were, Mr. Seif says.
“We need to be thinking about other ways of managing risk, not just for the Canada Pension Plan [which invests in alternatives such as real estate, infrastructure and private equity], but as much for Mrs. Smith with her $500,000 portfolio,” Mr. Seif says. “I believe risk management needs to be brought to the broad market.”
Indeed, alternative mutual funds – known as “liquid alts” because they can be traded daily – have caught on like wildfire south of the border, where securities regulators loosened the rules to make hedging strategies available in mutual fund form to small investors. Historically, hedge funds have been the preserve of the wealthy.
Assets of alternative mutual funds in the United States soared to $306-billion (U.S.) at the end of 2014 from $72-billion five years ago, according to data from Morningstar. Fees are much lower than for hedge funds. While some Canadian fund providers have taken steps in the direction of liquid alts, they still face constraints.
“The concept [of liquid alts] has not quite made its way to Canada as yet,” says Michael Burns, a partner at Borden, Ladner, Gervais LLP and chair of the Alternative Investment Management Association of Canada.
That could change before long. The Canadian Securities Administrators are working on amendments to securities law that would allow hedge funds to offer their wares to retail investors. Draft legislation is expected some time next year and a lively discussion is bound to ensue.
Hedge funds, limited as they are, would welcome the opportunity to sell to a much larger client base, Mr. Burns says. “It could dramatically increase assets under management for alternative and hedge funds in Canada,” he says.
While a proper hedge fund may underperform in a rising market, “where they really perform is on the downside,” he says.
Constrained though they may be, alternative mutual funds have garnered a loyal following among Canadian advisers and investors – for example, funds offered by Aston Hill Asset Management Inc. and the Exemplar funds offered by Arrow Capital Management Inc.
As of August, the Exemplar Canadian Focus Portfolio, managed by Veronika Hirsch, had a cumulative return of 128.25 per cent since inception in June of 2008, compared with 19.76 per cent for the 24 largest Canadian equity funds and 16.78 per cent for the S&P/TSX composite index.
While Aston Hill refers to its mutual funds as liquid alts, they are different from their U.S. counterparts and from traditional hedge funds. Canadian managers of alt mutual funds can sell short only up to 20 per cent of assets; hedge funds have no such constraint. Alt mutual funds have other limitations as well, the most important being that they are not allowed to borrow.
Alt ETFs are relative newcomers. Typically, they use passive strategies that seek to replicate an index (Horizons ETF Group) or computer models (Purpose Investments).
Purpose offers six strategies in either ETF or mutual fund form, all of which “have a role to play in portfolio construction,” Mr. Seif says. The Purpose Tactical Hedged Equity Fund, for example, offers a long-short strategy, hedging a portfolio of value stocks by selling the S&P 500 stock index short. A traditional hedge fund, in contrast, would hedge a portfolio of favoured stocks by selling short a matching group of laggards.
Mr. Seif says his strategy is less risky because the biggest losses come from selling short. “We don’t want to be the guy who is on the front page of the newspaper because he blew up.”
Horizons ETF Group funds are designed to replicate certain benchmarks, much the way other ETFs do, by using futures contracts. The Horizons Morningstar Hedge Fund Index ETF, for example, aims to replicate the Morningstar Broad Hedge Fund Index, a U.S. benchmark, hedged to the Canadian dollar.
“ETFs democratized investing, now we’re bringing strategies normally reserved for institutions and high-net-worth individuals to the masses,” Howard Atkinson, president of Horizons ETFs Inc., said in an interview. “Anyone who has a brokerage account can buy them.” Still, alt ETFs make up only a tiny portion of the Canadian fund universe, with assets of about $325-million, according to Morningstar Canada.
So far, the newcomers’ performance has been mixed. Some have done well, others have been a tad soggy.
“They’re not really holding up the way I would like them to,” says Craig Machel, vice-president and portfolio manager at Richardson GMP in Toronto. Mr. Machel, who specializes in hedging strategies, prefers active over passive management and is a big fan of Ms. Hirsch’s Exemplar fund.
“Veronika has zero interest in beating the index,” Mr. Machel says. “She just wants to get out there and buy stocks she feels are appropriate for today and tomorrow. She can make money regardless of what the TSX does.”
Hedged strategies can take a long time to prove their worth. As well, even traditional hedge funds have gone through some tough times. Global hedge funds suffered their steepest losses in August since the 2008-2009 financial panic.
“When markets are good, investors ask, why do I need this other stuff?” Mr. Atkinson says of hedge funds. But in a stock market drop like 2008, or last August, “they say, ‘Gee, I wish I had some alternatives.’”
Hedging also helps prevent investors from selling in the depths of a downturn. “Investors have to realize that you don’t just buy because a fund is trending well, or sell because it didn’t beat the market,” Mr. Seif says. “You have to believe in what the strategy is doing.”
If it isn’t doing what is was supposed to do, then you sell. That’s not what usually happens. Says Mr. Seif: “The biggest challenge most investors face is themselves.”
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