Q&A: How new regulations will change the alternative investments landscape

by Investment Research, Purpose Investments

Alternative investments are growing in popularity as investors seek out returns and income with lower correlation to traditional stocks and bonds. Such strategies have historically been offered through private hedge fund structures. But, on October 4, the Canadian Securities Association published final amendments to key mutual fund regulations known as NI 81-102, which will make it easier for investment managers to offer liquid alternative strategies to the general public.

The new rules formally create a new class of product called “alternative mutual funds,” which will have additional flexibility to pursue less traditional – but liquid – investment strategies as compared to a long-only mandate. While not exhaustive in scope, the following list compares some of the key features of alternative and conventional mutual funds¹.

Graeme Cooper is the product manager at Purpose Investments responsible for alternative funds. We spoke to Graeme about how the proposed changes to NI 81-102 will impact investors, advisors and the industry as a whole.

Q: What are the major changes expected to happen when the CSA moves ahead with its proposal on liquid alternatives?

We expect the implementation of the new rules will result in the broader acceptance of liquid alternative strategies within the Canadian retail market. Although the door has been open for such strategies through the existing commodity pool structure – and we have had product in the market for years – we can already see that the proposed regulations are bringing such strategies into the mainstream. This will be a game-changer, particularly given the timing as investors increasingly look for viable options to make a decent return while de-risking equity exposure with this bull market coming into its final innings.

There is precedent for this, as Canada is largely following the model established in Europe and the US. As this is new to Canada and there has been, to this point, little in terms of access to alternative investments, we expect the direction of alts will certainly be up. The only open question is ‘by how much?’ We expect the answer will depend to some degree on the direction of equity market volatility, with investors showing more of an appetite to explore alternatives as the bull market shows signs of greater stress.

Q: What do these changes mean for everyday retail investors?

These regulations will facilitate a much greater ease of access to alternative investment strategies that have historically been the domain of institutions and high-net-worth investors. Everyday investors will now be able to purchase alternative funds without meeting potentially prohibitive investment minimums and without dealing with the cumbersome paperwork associated with private hedge fund vehicles.

Added flexibility in portfolio construction is a good thing, but the additional degrees of freedom can involve different kinds of risk. Due diligence, particularly around risk management, is much more important in the alternatives space. Although it is wrong to think of hedge funds (the historical vehicle of choice for alternative strategies) as inherently riskier than beta-oriented strategies, greater leverage capacity carries higher potential risk if used inappropriately.

This is why selecting the right investment managers is critical. We believe it is important for managers to have experience running these kinds of portfolios and testing their respective risk management disciplines through periods of genuine market turbulence, such as the global financial crisis of 2008. In the right hands, alternative strategies should be expected to dampen portfolio volatility and improve risk-adjusted returns, and this is a good thing. We would just caution investors to do their research and seek out managers with direct experience using these tools through periods of significant market disruption – when diversification is most valuable.

Q: What do the changes mean for investment advisors and other professionals in the industry?

We think this is a great opportunity for advisors to become subject experts and differentiate their practices through the breadth of products they are able to incorporate in each respective portfolio solution. Institutions have embraced alternatives because they are useful tools to increase the probability of achieving their return objectives while reducing the risk taken in doing so. Retail advisors will soon have access to similar tools.

These tools can enable advisors to build more resilient portfolios, which is key to the value proposition of the products we offer at Purpose. With consensus building that this historical bull market is getting pretty long in the tooth, investors need viable options to de-risk and re-allocate into. Cash still doesn’t pay a lot and the duration of traditional fixed income is uncomfortable in a rising-rate environment. This makes for good timing with respect to the regulatory door opening to alternatives. We believe they provide the most compelling solution for advisors to de-risk client portfolios without meaningfully impairing expected returns.

Q: Purpose Investments has offered alternative products for many years – how was that possible under the old regulatory system? How will the changes impact those funds and any new offerings?

We have indeed been leaders in providing sophisticated alternative products under prospectus, in both ETF and mutual fund structures. Our flagship alternative fund, Purpose Multi-Strategy Market Neutral Fund, has been building a strong track record since October 2014. It recently won the 2018 Canadian Hedge Fund Award for Best 1 Year Return in the Market Neutral category.

At Purpose, we have always held the view that the strategy should be separate from the vehicle. In this sense, we looked at the strategies our portfolio managers could make available through offshore hedge fund vehicles, and cherry picked those that could be incorporated into the existing commodity pool regime. It’s surprising how little compromise was actually required, so we now find ourselves coming into this new regime with a tried and tested product.

To be honest, the new regulations will not have a meaningful impact on our existing products. They may open things up for some modest enhancements in our process of continuous improvement, but the bigger impact will be driving these strategies more generally into the mainstream. We feel we are well positioned in the market given our experience and pedigree with existing products and proven track records.

Q: How can alternative investments fit into a portfolio?

Alternatives can fill multiple roles in a portfolio, but these all generally distill to providing a diversified source of attractive absolute return that is uncorrelated to traditional market betas. The twin bull markets across bonds and equities have been historic in terms of duration and magnitude. With the interest-rates tailwind dissipating and now appearing to have definitively reversed, and equity valuations looking increasingly stretched, a lot of investors are questioning the future performance of the traditional balanced portfolio (60% equities/40% fixed income).

We are not in the business of making definitive calls on broad market direction, but we recognize the risks along with everyone else and believe they make a strong argument in favour of increasing alts exposure. We believe investors should be looking at de-risking both their equity and fixed-income allocations in favour of strategies that are proven to deliver diversification, particularly when it matters most. Even as cash rates recover from historic lows, a well-constructed alternative strategies portfolio provides a superior option in terms of reducing portfolio risk without making a meaningful compromise on expected performance.

Learn more about alternative strategies

See the full suite of Purpose alternative funds

Sources:
¹Ontario Securities Commission. “CSA Notice of Amendments.” http://www.osc.gov.on.ca/en/SecuritiesLaw_csa_20181004_81-102_alternative-mutual-funds.htm#4140s2csa

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