Liquid alternative funds: What advisers should ask before investing

As liquid alternative funds are on the horizon for being approved for retail investors, advisers need to exercise proper due diligence, an industry group says.

Liquid alternative funds – also referred to as liquid alts – are typically hedge fund or private equity strategies made available through a mutual fund account.

In 2016, the Canadian Securities Administrators published a paper proposing changes that would help facilitate more alternative and innovative strategies to be sold to retail investors. The 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.

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 2017 CIBC research report.

As the regulatory approval for these "liquid alternatives" funds remains in the pipeline, the Alternative Investment Management Association (AIMA) is recommending investment advisers – and retail investors – take the time to familiarize themselves with products that could be added to their investment portfolio in the near future.

“AIMA is committed to providing leading educational resources for retail advisers,” says Claire Van Wyk-Allan, director, head of Canada at AIMA. ““Given the expected influx of new product in the Canadian market under National Instrument 81-102 liquid alternatives, it’s especially important now to provide advisers and investors with tools to properly evaluate these and traditional alternative investments (offered under offering memorandum).”

In preparation for the upcoming changes, investment advisers should consider the following questions before investing in a liquid alternative fund, Ms. Van Wyk-Allan says.

• What is the fund’s investment objective and principal investment strategies?
• Have the objectives of the investment strategy changed in the past five years?
• Are the members of senior management of the investment manager, the portfolio manager and/or the fund directors personally invested in the fund?
• What is the background and experience of the investment manager and the investment team?
• What is the governance surrounding the investment manager and investment team?
• What are the features of the investment manager’s compliance culture?
• What risk management frameworks are in place (independent reporting lines, operational risk management, conflicts of interest, etc.)?
• From where are the underlying positional data, market data and any underlying models sourced for this strategy? Position limits?
• Who makes the portfolio management decisions and how are they made?
• Performance history? In what type of markets would this strategy be expected to outperform or underperform?
• What method(s) does the investment manager use to measure the total risk of a portfolio using this strategy?
• How much financial leverage does the fund use on average? Limits? Sources?
• Are there any capacity constraints?
• Offering documents, subscription agreements, and process for purchases and redemptions?
• Fees? Performance fees and calculation methodology?
• Valuation policy and frequency?
• How long would it take in normal market conditions and stressed market conditions to liquidate the fund without incurring unusual costs?
• What portfolio data does the investment manager provide to investors, and with what frequency and time lag?
• Who are the outsourced service providers? (Outsourced service providers might include: prime broker, fund administrator, custodian, auditor, accountant, legal)