20.4.1 Alternative Mutual Funds

Introduction to Alternative Mutual Funds

Alternative mutual funds, often referred to as “liquid alts,” have become a prominent financial product, blending the regulated environment of mutual funds with the sophisticated investment strategies traditionally associated with hedge funds. This section elucidates the distinctive structures, regulations, and strategies of alternative mutual funds while juxtaposing them with conventional mutual funds and hedge funds.

Structure and Regulation

Definition and Framework

Alternative mutual funds are designed to incorporate strategies beyond the conventional long-only equity and bond funds. They aim to deliver diversification and potentially higher returns by exploiting complex strategies like leveraging, short-selling, and investing across non-traditional asset classes.

Regulatory Environment

Alternative mutual funds operate under a strict regulatory framework provided by securities commissions, such as the Canadian Securities Administrators (CSA). This framework ensures that these funds maintain transparency, provide investor protection, and manage market risks effectively. Key regulatory highlights include:

• Leverage Limits: Regulations impose caps on the degree of leverage that can be used, limiting the potential for excessive risk-taking.
• Short-Selling: There are controls on the extent and mechanisms of short-selling to prevent market distortion.
• Liquidity Requirements: Funds are required to maintain adequate liquidity, reducing the risk of default and ensuring that assets can be sold to meet redemptions.

Diagram for Alternative Mutual Fund Structure

    graph TD
	    A[Alternative Mutual Funds] --> B[Investment Strategies]
	    A --> C[Regulatory Compliance]
	    B --> D[Leveraging]
	    B --> E[Short-Selling]
	    B --> F[Alternative Asset Exposure]
	    C --> G[Canadian Securities Administrators]
	    C --> H[Leverage Limits]
	    C --> I[Liquidity Requirements]

Investment Strategies and Diversity

Investment Approaches

Alternative mutual funds utilize diverse investment strategies that traditionally reside in the domain of hedge funds, while maintaining mutual fund-like liquidity and transparency. Here are key approaches and their characteristics:

1. Leveraging: Employing borrowed funds to amplify potential returns. It allows managers to enhance exposure without investing more capital but involves higher risk.

2. Short-Selling: Involves selling securities not owned with the intent of buying them back at a lower price. This strategy capitalizes on expected declines in asset prices, providing a tool for hedging or generating returns in falling markets.

3. Exposure to Alternative Assets: Engaging in markets beyond equities and bonds, such as commodities, currencies, real estate, and derivatives, aiming to capture unique returns and further diversify the portfolio.

Comparison with Conventional Mutual Funds and Hedge Funds

• Conventional Mutual Funds:

  • Focus on traditional investment vehicles with long-only equity and fixed income strategies.
  • Heavily regulated with stringent liquidity and transparency requirements.
  • Typically avoid complex strategies like leveraging and short-selling due to regulatory restrictions.

• Hedge Funds:

  • Utilize unrestricted and diverse investment strategies, including aggressive leveraging, short-selling, and derivatives trading.
  • Less regulated, often available only to accredited investors due to higher risk profiles.
  • Limited liquidity, often executing lock-in periods.

Glossary

• Leverage: The use of borrowed capital to increase the potential return on investment.
• Short-Selling: Selling securities not currently owned, repurchasing them later at a hoped lower price.
• Alternative Assets: Non-traditional investments including real estate, commodities, and derivatives.
• Liquidity: The ability to quickly buy or sell assets without causing significant impact on the price.

Additional Resources

• Canadian Securities Course Textbook
• Canadian Securities Administrators
• Financial Markets Regulatory Framework

Summary

Alternative mutual funds represent a pivotal evolution within the mutual fund industry, blending the strategic breadth of hedge funds with the regulatory oversight and investor access found in conventional mutual funds. They provide investors with diverse opportunities through leveraging, short-selling, and exposure to alternative assets while being stringently regulated to ensure investor protection and market integrity. As financial landscapes evolve, these funds are poised to grow in prominence, offering a unique blend of potential returns and regulated security.