Hedge funds have generally been out of reach for most investors.
These investments use leverage — borrowing to invest — or derivatives like options and commodity futures. They can also engage in shorting (betting against stocks and bonds).
And typically hedge funds have only been accessible to the ultra-wealthy and large pension funds.
But for the past 18 months or so, these strategies have been available to smaller Canadian investors in the form of liquid alternative mutual funds, or ‘liquid alts’ for short.
This new kind of mutual fund has been popular since liquid alts became available at the start of last year, growing to about $9 billion in 18 months.
And they truly can be a handy tool for investors in a world of increasingly volatile stock markets and low-yield fixed income investments.
"Liquid alternatives are a great tool to help add more balance into the traditional 60 per cent stocks/40 per cent bonds portfolio," says Grant White, a portfolio manager and investment advisor with IA Securities in Winnipeg.
While some liquid alts may be designed to add risk and potentially higher returns for investors, most are traditional hedge funds in the sense they aim to provide a steady return no matter how stocks and bonds fare.
"Liquid alternatives can provide a safe way to add more capital preservation to the portfolio and address risks like inflation that people are just beginning to think about," he adds.
White says he uses two liquid alts for his clients including Dynamic Alpha Performance II Fund, a long/short strategy fund. Based on a long-running hedge fund with a history of producing consistent, high-single-digit percentage annual returns, it can hold concentrated positions in stocks — going long, as it’s often called — while at the same time betting against (shorting) markets like the TSX Composite Index.
"Its managers have averaged around six per cent per return per year," White says. "The fund is meant to provide consistent returns no matter what the stock market is doing."
During the March downturn when stocks and bonds were down, for example, the fund was essentially neutral -- neither really down nor up.
The liquid alts category is quite diverse in the strategies it offers investors, adds Alan Fustey, portfolio manager with Bellwether Investment Management in Winnipeg.
It includes long-short equity funds, like Dynamic’s. It also encompasses alternative bond funds that "take unconventional approaches to bond investing, often trying to achieve returns uncorrelated with the bond market," he says. "So they can invest with a high degree of flexibility, like taking positions in high-yield foreign debt, for example."
Other liquid alts offer exposure to futures, including commodities like oil and gold, or they invest in derivatives such as swaps and options.
Then there are multi-alternative strategy funds that combine all the tactics listed above, he adds.
Mackenzie Investments was among the first Canadian investment firms to dip into the liquid alts market, and now has six mutual funds and one exchange-traded fund (ETF) in the category.
"The benefits of liquid alts is you can have a more stabilizing force in a portfolio," says Michael Schnitman, senior vice president and head of alternative investments at Mackenzie Investments in Toronto.
By allocating about 10 to 20 per cent of the portfolio to one or two liquid alts, investors can get outperformance "in both rising and falling markets," he adds.
Also many liquid alt funds have low barriers to entry. For example, the minimum investment for a Mackenzie alt fund is $500.
Among its offerings is the Mackenzie Alternative Enhanced Yield Fund, which aims to provide a five per cent annual distribution, paid monthly. To do this, the fund may use leverage (borrowing money) on low-yielding stocks and bonds to boost returns.
While worth considering, it’s important to understand how liquid alts work — as they are certainly not risk-free investments.
With respect to the aforementioned Enhance Yield Fund, for instance, that five per cent distribution isn’t guaranteed. As in more challenging markets, investors could see a return of capital as part of that distribution instead of it being made up solely of market returns.
Additionally most liquid alts come with higher than average management expense ratios (MERs).
"Fees are higher to manage alternative investment products than traditional mutual funds… given the complexity of research, trading and reporting of the underlying investments," Fustey says, adding that in some cases they exceed three per cent per year.
Those fees can make it more challenging for these funds to produce their intended returns.
Also of note is that because they often engage in much more complex strategies than the average mutual fund, you need to be fairly knowledgeable about investing. "Once you open the hood on some of these, they can be very complicated," White adds.
As a result it’s best to lean on your adviser to wade through the jargon and decide whether a fund is a good fit.
Another critical consideration is just how "liquid" the fund will be during times of market stress. Being liquid generally means investors can sell out the investment quickly.
"But if you allow someone to get in and out of those funds daily, there may be a bit of a mismatch with its underlying investments, which may not be as liquid," Fustey says. "And that could potentially lead to a run on some of these funds in really volatile markets."
One other point of caution: Although strategies used by liquid alts are often based on previously winning hedge fund formulas, they’re not guaranteed to work as well in the future — especially as the alternative marketplace becomes more crowded with investors.
"There are only so many of these opportunities out there, so the more money that keeps flowing into them, the harder it gets to find good opportunities," Fustey adds.
Still, liquid alt mutual funds are worth a look.
"A well-diversified portfolio that includes liquid alternatives isn’t a bad idea," White says. "But they’re not perfect, and people shouldn’t have blind faith in what they purport to provide."