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Canadian mutual-fund companies could soon be offering retail investors a class of complex investing strategies currently reserved only for institutions and high-net-worth individuals.

Regulatory approval for these so-called "liquid alternatives" funds, which are designed to maximize returns while providing downside protection in falling markets, could come as soon as next year.

The stakes are high for an industry being pummelled by an avalanche of investment dollars leaving managed funds in favour of low-cost, passive index products. Currently, alternative strategies in Canada are only available to institutional investors or high net worth clients with incomes of more than $200,000 a year or a net worth of $1-million. If approved for retail investors, liquid alternatives could have market potential of more than $100-billion of assets under management (AUM) over a five-year period, according to a recent CIBC research report.

"The advent of liquid alternatives is perhaps the most exciting regulatory development for the Canadian mutual fund industry in a very long time," Paul Holden, a research analyst with CIBC, said in the report. "It is particularly welcome at a time when global regulatory pressures are mounting and competition from low-cost passive strategies has taken a bite out of profitability."

Liquid alternative funds – also referred to as liquid alts – are typically hedge fund or private equity strategies made available through a mutual fund account. The Canadian Securities Administrators published a proposal paper that was open for comment in 2016. The paper was done as part of a larger fund modernization project that began in 2012 and states the proposed changes will "help facilitate more alternative and innovative strategies while at the same time maintaining restrictions that we believe to be appropriate for products that can be sold to retail investors."

The CSA is currently reviewing the industry comments and expects to publish its final amendments next summer.

The CSA's proposed changes are primarily aimed at developing a more comprehensive regulatory framework for publicly offered alternative funds (currently called commodity pools). In addition, the CSA would introduce or revise certain investment restrictions for these funds, including concentration limits, limits on illiquid assets and limits on cash-borrowing, as well as introduce disclosure requirements for alternative funds that would clearly highlight the investment strategies that differentiate these products from conventional mutual funds.

"Many mutual fund companies are preparing product capabilities ahead of the go-live date in order to be quick to market," Mr. Holden says. "[B]ecause of the niche nature of certain investment strategies and initial demand uncertainty, we would not be surprised to see a relatively high proportion of mutual fund companies start liquid alternatives with hedge funds acting as sub-advisers."

Firms such as AGF, IGM Financial, CI Financial, Manulife Investments, Fidelity Investments Canada and Franklin Templeton are all actively monitoring the development of the alternative fund asset class.

"We are definitely looking at [alternatives funds] and see an opportunity for our managers to participate in that space," says Steve Donald, executive vice-president of CI Financial.

Manulife Investments already has alternative asset management capabilities, which are being used in both a retail and institutional capacity outside of Canada, but will wait to thoroughly review the new rules before developing any products for Canadian retail investors, says Bernard Letendre, president of Manulife Investments.

"We believe alternatives can play an important role in the portfolios of Canadians and we eagerly await the final details of the regulatory framework," says Mr. Letendre. "We are optimistic that the new regulation will provide more possibilities to complement our existing mutual fund and ETF strategies to improve the likelihood of Canadian s successfully achieving their investment goals."

The CSA has proposed investment parameters for alternative funds that would enable hedge-fund-like strategies, but with limitations to protect investors from excess risk. Hedge funds are typically designed to provide investors with capital preservation and downside protection as returns are often uncorrelated to equity and fixed income markets. Like a mutual fund, a hedge fund is a managed, pooled fund that uses different strategies to invest and can include leveraging, derivatives and short-selling.

The proposed parameters by the CSA would see alternative funds offered to retail investors that include more borrowing, shorting and derivatives strategies. As well, the proposed rules would also enable levered investment strategies, similar to what is currently available in the exchange-traded fund industry. The recommended limits to the amount of borrowing and short-selling for these alternative strategies is one area industry commentators have been debating.

If offered to the retail investor space, the alternative fund structure combines the best of mutual funds with the best of private pools and hedge funds, says CIBC's Mr. Holden.

"Liquid alternatives combine the benefits of mutual funds, namely liquidity and transparency, with the benefits of private pools, namely investment flexibility," he adds. "Investment flexibility in private pools can provide access to higher return strategies, but perhaps it is the diversification benefits from uncorrelated strategies that provide the more significant utility for investors."

In the five years following the financial crisis, the U.S. liquid alts market has grown to $218-billion (U.S.) in AUM, up from $83-billion.

In Canada, mutual fund provider Franklin Templeton Investments Corp. stepped into the liquid alt space last year with the launch of an alternative strategies fund for accredited investors. The Franklin K2 Alternative Strategies Fund allows accredited investors access to a diversified selection of institutional hedge fund managers and strategies.

"We are pleased to open this fund to Canadians who are looking for an investment that can potentially reduce volatility in unpredictable markets, while providing the potential for attractive risk-adjusted returns," said Duane Green, president and CEO of Franklin Templeton Investments Corp. in Canada at the time of the launch.

The introduction of liquid alts to the retail mass investor would bring diversification benefits to Canadians, says Mr. Holden. As well, the introduction of retail alternative funds is timely for the active management industry that is facing pressures on multiple fronts, including competition from passive strategies – such as ETFs. Horizons ETF Management (Canada) Inc. has been offering similar alternative strategies to retail ETF investors since 2009. The company has $267-million (Canadian) in AUM in five ETFs in the liquid alt space.

"We believe there will always be a place for liquid alternatives in retail clients' portfolios, as well as, hopefully, continue to be in the ETF space," says Steve Hawkins, president and co-CEO of Horizons ETFs. "The Canadian ETF market is advancing more and more each day and it's only a matter of time before these strategies are mainstream among ETF providers .... [W]e have been a strong supporter of liquid alternatives from the start." The products can also be deemed risky – although the CSA proposal points out that "many are also designed to mitigate market risk, take advantage of market inefficiencies or to help produce more consistent returns under various market conditions."

Dan Hallett, a principal with High View Financial Group, says the introduction of alternative strategies could be a good addition to retail investors' portfolios, in theory, but it may come with higher fees than expected. "The idea with hedge fund [strategies], in part, is not to avoid risk but to isolate risk exposure," Mr. Hallett says. "So it does make sense to have exposure to more than one strategy, but the problem with some of the fund of fund structures found in these strategies is the double-whammy of opaqueness and multiple layers of fees."

The intricate layers of liquid alternative strategies may pose an issue for the adviser community as regulators are currently looking at whether mutual fund advisers should be required to obtain additional proficiency requirements specific to alternative funds before being able to sell these products.

While the independent fund companies will be set to launch if the green light is given, analysts predict the banks will not be early adopters of the product, rather will monitor the development of the liquid alt market closely from the sidelines.

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ALTERNATIVE OPTIONS

Canada's securities regulators are looking at opening the door for mass retail investors to the liquid-alternative-fund market in 2018, but for investors looking to tap into similar hedge-fund-like strategies before then, which could provide downside protection in the event of a market decline, here are four options to consider:

Manulife Investments

Manulife's Global Absolute Return Strategies seeks to provide positive absolute returns over the medium to long term, whether markets are rising or falling. Accessible from Manulife as a segregated fund or – for eligible investors – a private mutual fund, both invest in the underlying GARS investment strategy managed by Standard Life Investments Ltd. (which invests primarily in a mix of derivative contracts, equities, fixed-income securities and cash on the global markets). The management-expense ratio for the segregated-fund option is 2.93 per cent, and 2.62 per cent for the adviser series of the private mutual fund.

Franklin Templeton

Franklin Templeton entered the alternative-fund space last fall when it launched the Franklin K2 Alternative Strategies Fund. The actively managed fund is currently only available to accredited retail and institutional investors in Canada and has a management fee of 1.9 per cent (for the O series fund). Managed by portfolio managers David Saunders, Brooks Ritchey and Robert Christian, the fund's principal investment goal is capital appreciation with lower volatility relative to the broad equity markets. To achieve that goal, the fund allocates its assets across multiple alternative hedging strategies, which include long/short equity, relative value, global macro and event-driven.

Horizons ETFs Management (Canada) Inc.

Sub-advised by CIBC Asset Management Inc., and with a management fee of 0.95 per cent, the Horizon Absolute Return Global Currency ETF uses currency as an alternative strategy for investors. Historically, a diversified basket of global currencies has a low correlation to stocks and bonds. With the ticker HARC, the fund seeks to generate positive absolute returns through long and short exposure to selected global currencies and generally holds Canadian short-term fixed-income securities using derivative instruments to gain its exposure to selected global currencies.

Purpose Investments

The Purpose Multi-Strategy Market Neutral fund uses classic hedge-fund investment strategies such as long/short equity, momentum and carry themes within currencies and commodities. Purpose offers both ETF and mutual fund classes of the fund, which has a management fee of 0.95 per cent. With the ETF ticker PMM, the fund utilizes equity, commodity and currency exposures that offer little to no correlation to the capital markets. The fund can also provide investors with a low correlation to other assets and potentially higher risk-adjusted returns, while using less leverage relative to other long/short fund strategies.

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