20.4.4 Alternative Mutual Funds (liquid Alts)

Background

Until recently, Canadian retail investors had limited access to alternative investment strategies, largely through closed-end funds and commodity pools. In these commodity pools, managers had limited freedom compared to conventional mutual funds regarding the use of derivatives and leverage.

Commodity pools were prohibited from short selling non-derivative securities, which reduced opportunities for diversification during market downturns. Alternative investment strategies have been proven to offer significant diversification away from traditional long-only investments in equities and bonds.

This landscape has changed with the Canadian Securities Administrators (CSA) modernization of Investment Product Regulation (NI 81-102). This modernized regulation increases access for retail investors to alternative strategies through mutual funds formally known as alternative mutual funds, or liquid alternatives (liquid alts). Regulation changes have effectively replaced commodity pools with alternative mutual funds and broadened these funds’ allowable activities.

Did You Know?

Commodity Pools existing before the regulatory change automatically became alternative mutual funds when the CSA modernization amendments took effect on January 3, 2019. They had until July 4, 2019, to comply with the new rules for alternative mutual funds.

New rules for alternative mutual funds allow greater usage of derivatives, leverage, and short selling than conventional mutual funds and permit a higher single issuer concentration. However, these alternative mutual funds aren’t as flexible as hedge funds in these activities and have similar restrictions on investing in illiquid investments as conventional mutual funds.

Regulatory Changes and Comparison

In the United States, the Securities and Exchange Commission (SEC) revised mutual fund regulations to include alternative investment strategies in 2004. The number of liquid alt funds and their respective assets under management grew slowly from the regulatory change until 2008. Afte the 2008 financial crisis, U.S. retail investment in liquid alt funds grew rapidly as investors began to recognize the benefits of diversification and capital preservation.

According to Morningstar, by the end of 2019, there were 2,663 liquid alternative products, which include mutual funds, ETFs, and closed-end funds, holding $882 billion in assets, compared to the $5 trillion invested in overall alternatives.

Conventional Mutual Funds vs. Hedge Funds

Historically, conventional mutual funds and hedge funds differed in several key aspects:

• Liquidity: Conventional mutual funds offered daily liquidity while hedge funds had limited liquidity.
• Transparency: Conventional mutual funds offered high transparency, whereas hedge funds had limited transparency.
• Return Objectives: Conventional mutual funds aimed for the highest relative return versus their peers, whereas hedge funds sought absolute (positive) returns regardless of market conditions.

Benefits and Considerations

Alternative mutual funds combine many desirable attributes of conventional mutual funds and alternative investments, providing retail investors with the following benefits:

• Access to more complex investment strategies previously limited to exempt investors
• Objectives focused on earning absolute returns during all market phases
• Transparency, daily liquidity, and investor protection akin to conventional mutual funds, along with riskier, potentially higher return strategies
• Generally lower minimum investment requirements compared to hedge funds
• Typically lower fees compared to hedge funds

Did You Know?

Alternative mutual funds generally charge lower fees than hedge funds, though they maintain similar performance fee structures regarding high-water marks and hurdle rates. According to the Alternative Investment Management Association (AIMA), average performance fees for alternative mutual funds are around 8%, versus hedge funds which charge up to 20%. Both also charge management fees, generally 1%-2% of assets.

Trade-Offs and Limitations

Not all alternative strategies can be employed within liquid alternatives. Certain strategies necessitate a lockup period to align client liquidity with the time horizon of the fund’s strategies. Since liquid alternatives offer daily redemptions, they must maintain a degree of liquidity. As with conventional mutual funds, liquid alternatives can invest only up to 10% of the fund’s Net Asset Value (NAV) in illiquid assets as per NI 81-102.

Illiquid assets are defined as portfolio assets that can’t be readily disposed of via widely available public market quotations at an amount approximating quarter-end values.

Examples of Illiquid Assets

• Penny stocks
• Ownership interests in private companies
• Art and antiques
• Certain bonds and debt instruments

Therefore, a hedge fund’s potential returns are generally higher than those of alternative mutual funds.

Glossary

• Alternative Mutual Fund: A type of mutual fund that employs alternative investment strategies like derivatives, short selling, and higher leverage while offering daily liquidity and better transparency to retail investors. Also known as liquid alts.
• Commodity Pools: Investment funds that pool capital from many investors to trade in commodity futures, swaps, and options markets. Legislatively replaced by alternative mutual funds in Canada.
• NAV (Net Asset Value): The value of a fund’s assets minus its liabilities, divided by the number of outstanding shares.

Key Takeaways

• Liquid alternatives or alternative mutual funds bring complex alternative investment strategies to retail investors while maintaining some restrictions inherent to conventional mutual funds.
• Regulatory changes by the CSA and SEC facilitate increased retail investor access to these strategies.
• Liquid alts generally charge lower fees than hedge funds but may also utilize performance fees with high-water marks and hurdle rates.
• Due to liquidity requirements, liquid alts cannot employ all strategies available to hedge funds, particularly those needing lockup periods.

Frequently Asked Questions (FAQs)

Q1: What are the main differences between alternative mutual funds and hedge funds?

A: Alternative mutual funds offer daily liquidity and higher transparency than hedge funds, making them accessible to retail investors. They charge lower fees but have some restrictions which hedge funds do not have.

Q2: How have regulatory changes impacted the availability of alternative mutual funds?

A: Regulatory changes by the CSA and SEC have increased access to alternative mutual funds for retail investors by allowing these funds to use more complex investment strategies like greater leverage, short selling, and higher issuer concentration limits.

Q3: Can liquid alternatives invest in illiquid assets?

A: Liquid alternatives can invest up to 10% of their NAV in illiquid assets, similar to conventional mutual funds. This rule requires these funds to maintain liquidity for daily redemptions.

Q4: Why do alternative mutual funds generally charge lower fees compared to hedge funds?

A: Though both types of funds have the ability to employ complex investment strategies, alternative mutual funds are designed for retail investors and are regulated to keep fees lower for consumer protection while providing performance linked fees similar to hedge funds.