5 factors that may help maximize the value of liquid alternatives
Regulatory changes enacted earlier this year have allowed retail investors in Canada access to liquid alternative funds for the first time. Unsurprisingly, this has led to increased attention from advisors on how to assess and access this broadened investment opportunity set. Indeed, investment strategies and portfolio management techniques that were, historically, the exclusive domain of pension funds and wealthy or accredited individuals are now accessible to individual investors.
As the following exhibit highlights, Canadian pension funds have, on average, 32.7% of their total assets broadly allocated to alternative investments 1.
1Source: OMERS 2017 Annual Report www.omers.com Ontario Teachers Pension Plan 2017 Annual Report www.otpp.com Caisse de depot et placement du Quebec 2017 Annual Report www.cdpq.com Canada Pension Plan Investment Board Fiscal 2018 Annual Report www.cppinvestments.com Pension Investment Association of Canada (“PIAC”) Asset Mix Report December 31st 2017 www.piacweb.org British Columbia Investment Management Corporation 2018 Annual Report www.bci.ca
Just as pension funds use alternatives to help them achieve desired investment outcomes, it’s expected that individual investors will increasingly include alternatives in their portfolios. In fact, the Canadian Imperial Bank of Commerce (CIBC) has estimated that assets under management in the liquid alternatives space could reach $50 to $100 billion within five years2.
While alternative investments can play a major role helping individual investors deal with today’s investment challenges—such as equity market volatility, low bond yields and general economic uncertainty—advisors must exercise thorough due diligence before investing in liquid alternative funds. Through the course of that due diligence process, what exactly do advisors need to focus on in order to navigate some of the key risks associated with this asset class? We believe there are five key factors at play in order to get liquid alternatives right and maximize the value of these strategies in client portfolios.
1. Greater dispersion across strategy and manager returns
Relative to traditional stock and bond strategies and investment managers, alternative investments display much greater dispersion between the top and bottom performers. For example, the difference between the top- and bottom-performing strategies has averaged more than 23% per year over the last 20 years3. In addition, dispersion of returns across the top- and bottom-performing managers has averaged more than 14% over the three years ending June 30, 20194. The implication for investors here is that consistently picking the best-performing strategies and managers is hard—so it is probably best not to rely on a single strategy or manager. In order to mitigate the risks associated with poor strategy and manager selection, we believe a multi-strategy, multi-manager approach to liquid alternatives is warranted.
2. Access & the importance of scale
Across the spectrum of alternative investment strategies, there are thousands of individual managers and strategies. In addition, many of the best alternative investment managers are only available to large institutional investors and aren’t headquartered in Canada. Moreover, many of them do not advertise, and in some cases may be closed to new investors. Given the sheer scope of investable products, specialist resources with sufficient scale and depth are required to identify, evaluate and access top-performing alternative investment products on a global basis. We believe a large and experienced global investment team—with on-the-ground professionals in North America, Europe and Asia Pacific—who can meet with managers in local markets, is critical to this endeavor.
3. Specialist expertise
The term alternative investments encapsulates a diverse range of asset classes, strategies and investment techniques. As such, it’s important to have a specialist investment team with the requisite knowledge and expertise across the full spectrum of alternatives. For example, a fundamental understanding of an alternative investment strategy, its performance drivers and the current opportunity set is more likely to provide a reliable guide to future performance of the strategy than relying on historical performance alone. Past performance, as we all know, is no guarantee of future results.
Whether it be research, portfolio construction, operational due diligence or risk management, we believe investors who are equipped with specialist expertise have a distinct advantage when investing in alternatives.
4. Dynamic management requires increased oversight
Alternative investment managers typically have the ability to utilize different investment techniques, such as short selling and leverage. By applying these portfolio management tools—without the constraint of a benchmark—they may dynamically adjust portfolio exposures based on their investment views. This contrasts sharply with traditional investment managers, who are often limited in their ability to make real-time adjustments due to needing to conform to benchmarks, against which their performance is measured.
At the end of the day, working with a team that has constant interaction with research analysts, portfolio managers and traders—in order to understand current portfolio positioning and ensure its consistency with a manager’s stated investment process—is critical to helping boost the potential to achieve desired investment outcomes.
5. Operational due diligence matters
Operational due diligence (ODD) assesses the potential material risks posed by investment managers that may significantly impact clients from an operational, financial, regulatory or reputational perspective. This includes a review of factors such as valuation, compliance, trading, operations, management company and systems risks. This process is distinct and complementary to manager research, which focuses on the investment merits of a particular manager, i.e., quality and experience of the investment team, their investment process and sustainability of their investment edge.
ODD is critical in the alternatives space because history has shown that many alternative investment fund failures are the result of operational risk deficiencies. With that in mind, having an independent team evaluate managers from an ODD perspective—with the power to veto any investment—provides an additional layer of oversight that is essential to protect investor interests.
Bottom line
In our view, successfully incorporating liquid alternatives into portfolios requires a unique mix of capabilities, including scale, specialist expertise, in-depth due diligence and rigorous oversight. With an experienced hand at the wheel, advisors are well positioned to maximize the benefits of alternative investments in portfolios—and in doing so, help clients pursue their desired outcomes.
2CIBC “Alternative Mutual Funds: Growth Potential Looks Solid Coming Out of the Gate” July 2019
3Source: Callan & Associates, Russell Investments, December 31st 2018
4Source: Russell Investments, HFRI June 2019