As a Portfolio Manager that previously managed a hedge fund in Canada, I understand the importance of asset allocation strategies that aim to reduce volatility in a portfolio, while maintaining or enhancing returns. To achieve this objective, diversification across asset classes is necessary, and not within asset classes. For example, there have been numerous studies demonstrating that correlation between Canadian equities and US equities (within asset classes) increase significantly during periods or market stress.

Looking across asset classes, the equity and fixed income buckets were typically the mainstream options for cross-asset diversification 20-30 years ago in a liquid portfolio. The term “liquid” is defined as a security that could be sold and converted to cash within 1-2 days of trade date. This would include publicly traded stocks or bonds for example, and perhaps a small, direct allocation to commodities for larger portfolios.

Liquid would not include direct investments in assets such as real estate, infrastructure or offering memorandum funds, as the process of converting these assets to cash can take weeks or months, especially during periods of market stress. For example, Blackstone Inc. manages one of the largest real estate investment funds globally (BREIT). On December 1, 2022, Blackstone’s BREIT began restricting withdrawals due to a surge in redemption requests for investors. In its most recent update, Blackstone’s fund continued to throttle investor redemptions. Presumably, if investors are expected to accept increased liquidity risk, the returns and volatility should be superior to other investment options.

 

Understanding Liquid Alternatives

Liquid alternatives, often referred to as "liquid alts," were initially proposed by the Canadian Securities Administrators (CSA) in March 2013. Framed as the “modernization of the Canadian investment funds industry,” the liquid alts proposal aimed to level the playing field for all investors in Canada. In late 2018, the CSA issued the final rules for liquid alts in Canada and made the important step of offering Portfolio Managers the ability to reduce volatility in portfolios, while maintaining or enhancing returns.

The types of liquid alts investment strategies that we can now access when managing our discretionary, client portfolios might include investment funds that utilize leverage, derivatives, or short positions (profiting when securities go down in value). Importantly, the restrictions put on these investment funds by the CSA, allow investors to sell and convert to cash in two days (recall our earlier definition of liquid).

 

The Role of Liquid Alternatives in Asset Allocation

Now that we’ve defined liquid alts in Canada, here are the factors we weigh during our research:

1. Diversification: Liquid alternatives offer exposure to strategies that don't necessarily correlate with traditional asset classes like stocks and bonds. For instance, long/short equity strategies can provide returns that aren't directly tied to broader equity markets, helping to reduce overall portfolio risk.

2. Risk Management: Liquid alternatives often employ risk management techniques, such as hedging and derivatives, to mitigate losses during market downturns. This risk-mitigation aspect can be particularly valuable during periods of market volatility, contributing to a more stable investment experience.

3. Enhancing Returns: Liquid alts aim to generate positive returns in various market conditions. For example, market-neutral strategies seek consistent returns by capitalizing on relative price movements between long and short positions. This can potentially enhance portfolio returns while reducing overall risk.

4. Liquidity and Transparency: Unlike traditional alternative investments, such as private equity or real estate, liquid alternatives offer daily liquidity and transparency. This accessibility allows investors to monitor the underlying holdings and adjust as needed.

Look for our next edition in our series on liquid alts. We will explore how we evaluate each liquid alt and decide how it fits with our asset allocation strategy.