Diversification and the importance of asset allocation have long been fundamental principles of sound financial planning and portfolio construction. Today in our Masterclass, we will explore liquid alternatives and what amendments to national instrument 81-102 means to Canadian advisors and their clients.
Clare O'Hara: Diversification and the importance of asset allocation have long been fundamental principles of sound financial planning and portfolio construction. Earlier this year, Canadian regulators put rules in place that will now allow portfolio managers and ultimately retail investors the ability to employ strategies that were previously restricted, such as leveraging and short-selling. Similar regulations allowing retail investors into the liquid alt space in the United States were passed in 2013 and by the end of last year, the liquid alts market had expanded to $225 billion. Now Canadian markets and Canadian investors are looking to replicate that success. Today in our master class, we will explore liquid alternatives and what amendments to national instrument 81-102 means to Canadian advisors and their clients. To lead us through today's discussion, we have David Picton, president, CEO and portfolio manager with Picton Mahoney Asset Management.
Clare O'Hara: Brooks Ritchey, senior managing director and portfolio manager for Franklin Templeton's, K2 Advisors team in Connecticut, and Lindsey Holtz, managing director asset management for Connor [inaudible 00:01:17]. David, let's begin with you. What's the best way for an advisor to explain liquid alternatives to end clients? Is there a simple concept that they can use to help their clients understand why adding liquid alts to portfolio would be beneficial?
David Picton: Great question, our firm Picton Mahoney has been managing products for over a dozen years in the hedge fund space, has had to do a lot of missionary work to try and educate people on the differences between the different kinds of alternative funds. The way I boiled it down to is very simply to look at return streams. Everybody knows that in the very long run, equities have had fantastic returns and have been the best performing liquid or market asset class that's available. Then why is it that an investor would have equities plus bonds in their portfolio? Well, the reality is that bonds have had good returns too, and most importantly, when the two of them have been combined, there've been periods of time where they've act differently from each other.
David Picton: In other words, stocks are the best performer, but to enhance the quality of the return and remove some of the volatility, you should add bonds into the mix. I would use that exact same analogy for liquid alts as well. In other words, stocks act a certain way, bonds act a certain way. If you could get your alternative funds to act a different way from these two and have a positive return stream attached to it, you'll basically improve the quality of the returns, the diversification benefits of your portfolio.
Clare O'Hara: Great. Brooks, what's your take on that?
Brooks Ritchey: Well, similar to David. The term liquid alternatives, it's another choice. It's another investment that has different characteristics than just long only equities, long only fixed income. If the equity markets depend on the trend in economic growth and the trend in equity markets in general, and bonds depend on a different set of macroeconomic factors, they're both dependent on a trend. What if there is a degree of uncertainty? What if you're trying to find a strategy that's looking for winners in the equities or in the bond market, but just in case the trends are not positive, they're hedging out some of the market risk using short sales, using hedges? Equities long only, great asset class over the long-term agree with David, fixed income, fantastic asset class if you're looking for an income type of a lifestyle. The problem we've gotten these days is yields are low, interest payments are low. The problem in equities might be that we're late cycle.
Brooks Ritchey: What if you could invest in a set of managers that are looking for good equities, good bonds, but just in case the cycles are shifting, they're hedging out some of that directional risk by looking for the laggards or those equities and bonds that get decline. It's really very simplistic. They are looking for winners and they're removing a lot of the market risk by selling short or betting against laggards. Its commonsensical, but it is a different profile than just buying bonds or just buying equities.
Clare O'Hara: When we talk about hedge funds and alternatives, many Canadians are still associating those with high risk investing. Brooks, maybe just staying on you, how has the industry matured? And maybe you can talk about some of the misconceptions that investors need to overcome.
Brooks Ritchey: Sure, and David mentioned education. Lindsey may mention it as well. We spend a lot of our time in at Franklin Templeton trying to give people comfort, that these are not complicated mysterious investments. There is a change under way over the last 30 years that I've been involved with hedge strategies where the ... Some of the concerns over fraudulent managers or high volatility or this is too confusing for me to explain to my advisors or to my clients. That seems to be changing. The irony and I'm almost certain the panel's going to talk about this. The irony is that alternative investments, liquid alternatives, especially with a regulatory oversight, they are actually about the same risk level as fixed income products. They're much less risky. They're only about 25%, one quarter the risk of equities. That sentiment, that legacy view of hedge funds and whatnot as being quite risky seems to be changing.
Brooks Ritchey: The irony is because they're long some securities and they've hedged out a lot of the market risk with other securities, it's much less risky than equities and it's about as risky or as volatile as fixed income. Very quickly I'll add to that. The fees that people were worried about on hedge funds, I'm sure the viewers are thinking, oh, they're too expensive. Well, those have come down a lot. The fees in the hedge fund industry, since I've been involved, have come down from 2% management and 20% incentive fee or performance fee to a as low as some of the liquid alternative products are 75 basis points management fees and no performance fees. The fees, which was frustrating to investors, that's coming down. It probably is going to come down a bit more. The transparency, the mystery that's being softened up as people understand, it's a low risk access to performance.
Brooks Ritchey: As the markets become more uncertain, and people are seeing not as much interesting come on their GICs or their bond portfolios and they're seeing more draw down pressure in equities, I think they'll get more comfortable with hey, what's that over there. That seems to be working.
David Picton: If I could add to that, the difficulty of this is actually an ironic proposition. If I look at most equity related funds, I know I'm going to get the equity market return plus or minus 5%, because they're basically fully related to what happens in global markets for the most part. The same thing with most fixed income insurance. I'm going to get a fixed income beta like return plus or minus a couple of percent. The thing with the new alternative funds is that we're going to have all kinds of different strategies. Some of them are going to look like equities. Some of them are going to look like bonds and some of them are going look like diversifiers in the mix. The challenge for the investment community as a whole is to try and understand how it is at this particular solution that's being sold to me as some sort of risk adjusted benefit. How it actually fits in the context of these two other things that I already own. That's where the big education is going to happen.
Lindsay Holtz: I think the thing we haven't talked about here is the institutionalization of the operations infrastructure behind hedge funds. Where hedge funds were known as this high risk, not transparent, mysterious vehicles that were available to high net worth clients and private banks. In 2000s we saw quite a bit of institutional money come into hedge funds, and that upped the bar of what it was required to be and to operate a hedge fund strategy. While we saw in the financial crisis the demise of some highly levered and or illiquid strategies, people have learned a lot from that. Between the institutional money coming in and some of the learnings from the financial crisis, we've seen a much-heightened focus on the operations infrastructure behind these more complex strategies.
Lindsay Holtz: Being transparent with your investors, having a real risk management protocol, being focused on your counter party risk and having an operations infrastructure behind your business, that's not an edge anymore. That's a requirement to be in these strategies. That's really helped bring the risk down that investors were exposed to in the early days of hedge funds. Then to pick up on something Brooks said, when you layer on the regulatory environment on top of that, so you take the 81-102 regime, or '40 Act in the US, or UCITS in Europe. That's putting further limitations on how far a manager can push the risk spectrum of what they're doing. It also ensures a certain level of transparency to investors so they can be sure that they understand what's in the portfolios that they're investing in.
David Picton: Yeah, I wanted to add. I'm glad Lindsey brought up the regulatory oversight. A good portfolio management firm welcomes regulatory oversight. It's another set of eyeballs looking to make sure that the managers or even the corporate governance and that portfolio management firms are doing the right thing. Imagine not having a speed limit on the highway, asking people to please drive below 100 kilometers per hour. It's much safer for everyone, but there's a least and maximum, on leverage, on liquidity or illiquidity. I actually, ironically, or counter intuitively, I had a session this morning and I said, I welcome regulation, because I need to know where the speed limit is.
Clare O'Hara: Lindsey, taking all that into consideration as a retail investor, what are the things the clients should consider when they're looking at all these new funds coming out?
Lindsay Holtz: Sure. I focus on three areas for that. The first is why are you adding liquid alternatives to your portfolio in the first place? Dave picked up on this a little bit. Are you adding it for diversification benefits? Are you adding it to enhance returns? Why are you doing this, because adding alternatives just for the sake of adding alternatives with no plan of how that fits into your asset mix, that's not a good way to start this. Once you've identified the objective that you're trying to achieve, then you want to identify funds and strategies that will meet those objectives, and there's lots of promises out there. How do you decide whether to go in this fund or that fund? We can all look at historical track records. Some of the track records that will be coming out and liquid alternative funds are simulated or back tested, and we all know all the caveats that come along with that.
Lindsay Holtz: 11:41 I do think you need to look at the experience of the asset manager that are delivering these products. I certainly wouldn't want an asset manager learning how to short, and learning how to use leverage with my money. You definitely want to focus on those institutions that have some history, and actually delivering these products already to the retail environment through the OM Avenue, or the institutional investors. That's been brought up already, but also fees. Fees are not just a consideration for liquid alternatives or hedge fund products, fees are consideration for any product that you're investing in. You want to make sure that you're aligned with the manager in terms of how they get paid for actually performing, because there's far too many fee structures out there where the manager earns a pretty lofty flat fee just for showing up.
Lindsay Holtz: They don't really have to deliver anything above market returns for you. You really want to focus on that fee structure being aligned and being appropriate for the mix of market return and added value that you're expecting from the strategy that you're investing in.
Clare O'Hara: David, your thoughts on the message to clients what they should be looking at?
David Picton: It's exactly like Lindsey said. It's why, really why you're looking at this? You will see an absolute tsunami of products coming down. Speaking to compliance departments and some of the major departments within some of the banks, they're trying to prepare for the tsunami. They put with high risk ratings on everything to start off with, just to take that away for now. They're kind of a little bit concerned as to how this plays out. The education process absolutely has to include this, why. Why, the farm in question. What kind of pedigree do they have, and risk controls has Lindsey mentioned. Why this particular product has to be a massive part of it. They know your product will ... Has to absolutely be enforced with these, because they have massively different objectives. Our industry spent so much time focusing on 3,000 mutual funds that have basically the same objective and now we're going to have a limited amount of these funds that have dramatically different objectives.
David Picton: You're going to have to get through that, and then finally, why now? Why does it make sense now, this point in time? If you can you get through those three questions, I think these become very simple additions to your portfolio.
Clare O'Hara: Brooks, David brings up a good point that it's tempting to paint alternative or liquid alternative funds with the same brush, but there are a number of different alternative strategies that, that are coming to market and have already been in the market. Can you tell us a bit about some of those strategies, as well, as maybe why it could be interesting to use multiple strategies within the portfolio?
Brooks Ritchey: Sure, Lindsey touched on this. A lot of hedged strategies, a lot of liquid alternatives are vastly different. I think David was alluding to this as well. When you buy an equity mutual fund or an ETF of Equity Focus ETF, you're going to get pretty similar risk profile, return profile, volatility profile same thing in the bond arena. You're exactly right, and my panel mates are correct. It's going to be a more disparate type of product. I call it a product class. There are liquid alternatives that are being launched that are multi strategy, sort of like a balanced fund, but all wrapped into one where they've got, and we'll speak about the different hedge strategy classes. They might have a component that's equity long/short. These are managers or trading programs that are looking for stocks to buy that they like. As I mentioned earlier, stocks to sell short to hedge out the equity market risk.
Brooks Ritchey: That's known. Many of the viewers may know that the most classic hedge fund strategy called equity long/short. Sounds like they're equity long short. Another ... A multi strategy product might have another component that's Event-driven. Thank goodness that sounds a little bit like what they do. These are managers that are trying to generate performance by investing in corporations that are going to raise ... That have raised their dividends, or that are merging with another company, a corporate event. Maybe they're spinning off a unit. Those are corporate events that tend to create a nice performance opportunity. Maybe they're hedging out the market risk by selling the equity index futures, but they're buying, I forget who it was a week or so ago that spun off a division and the stock rally 12, 14%. You've got equity long-short. They're looking for winners and hedging out laggards. You've got Event-driven. They're looking for corporate events, mergers, et cetera.
Brooks Ritchey: You've got Macro/CTA which is the old-style hedge fund strategy class where their managers that will buy the bond market in the US and they'll sell short the bond market in Germany. That is a trade that we're seeing in some of the macro and commodity trading advisors now, where yields in the US are higher than in Germany. They'll play a relative value trade in the macro asset classes. Stocks, bonds, currencies, et cetera. You've got equity long/short, Event-driven, macro/CTA, and then the lowest volatility sub strategy class is called relative value. That's, as it sounds, they're looking at more in the fixed income world. They're looking for bonds that they think the corporate credit is improving to own, they'll buy those bonds, but to take out the interest rate and the bond market risk, or maybe even to bet on a company that might not quite make their bond payments.
Brooks Ritchey: They'll sell a short corporate or a high yield bond as an offset to the longs. That would be the four core strategies. Anyone can Google hedge fund strategies and they'll see those four. Some groups are coming out with a multi strategy, liquid alts funds that'll rotate amongst those four sub strategies. Lindsey mentioned. You need to know if it's a single strategy type of alternative product. Is it the risky sub strategy class, like equity long/short can be somewhat volatile, or is it the lower risk sub strategy class like relative value? It's a long-winded answer to a follow up to David and Lindsey's points. These are not going to be very homogenous product class. You do need to know the firm that's been doing this for 12, 24, X number of years. You need to know the infrastructure and the reporting and the controls they have in place. You have to know the individual product. What are they doing? Are they focusing on a sub strategy, or is it about a ... More of a balanced liquid alternative?
David Picton: If I could follow up on that, if I'm an investment advisor in Canada, and I'm pretty sure this might even apply around the world. I'm going to have, in Canada, 20 household US growth stocks. I'm going to have a bunch of Canadian names that pay dividends. I'm going to have a bunch of banks, because my historical cost based is so low. I can't sell those. Then I'm going to augment that with either a couple of fixed income funds, or maybe some global equity product. That's the traditional portfolio, plus or minus 5% for everybody in Canada. If I was looking at that portfolio, they don't realize it, but they have a massive interest rate bet in there. If you do any kind of risk analysis metrics on that particular portfolio, they have one dramatically from the long-term decline in interest rates. Why would you ever change that?
David Picton: If I was looking at that, I would say one of these liquid alt things, alternative products, hopefully has a solution to that particular problem. On our firm, what we try to do is structure our products by solution. If you believe you have too much rate risks, here is an income related products that hedges out the rate risk in your portfolio. If you believe you need something that is uncorrelated to both markets and interest rates, here's a market neutral strategy that we can show you how has it been uncorrelated to those. If you want a little bit less beta but maybe still stock selection, here's a long short product to do it. Again, if you add it to Brooks this point, wrap them all together into some product, we can do that too.
Clare O'Hara: Can you talk a little bit about the risk ratings? Are those varying?
David Picton: Well ironically the OM versions of some of these products have medium risk ratings at a lot of the different banks. We rate though a lot of these ones medium risk as well. Brooks made the point earlier about leverage, immediately gets a red flag in the industry, and a lot of the banks compliance departments immediately go, oh, this is a high risk. Ironically, if you hedge out market risk by going long something you like and short something you don't like, you're really, unless you go crazy in your mismatching, you really have less risk than a typical portfolio of equities for instance.
Brooks Ritchey: That's good leverage.
David Picton: Exactly.
Brooks Ritchey: That's a key point, and I don't want to take time from Lindsey, but you can use derivatives and or leverage to enhance and increase risk, bad or reduce risk. That's the key educational point that we're seeing an improvement in. You're adding more leverage, but it's the ... The sign is different. You got plus leverage and minus leverage, then out to a low to medium risk rate.
Lindsay Holtz: I think what's going to be challenging for advisors is that, the head offices have taken a really broad range of approaches to the risk ratings that they're applying to these products. As you said, some of the banks are saying, leverage is bad, high risk rating until you prove us otherwise. Others are taking the risk rating that come out of what our prospector says. Low to medium or medium risk which is what ... We wouldn't put it in there if we didn't believe that that was the appropriate risk level. Because you say, we're using derivatives and leverage as a way to bring down the risk in the products and reduce the market risk that's there. You've got the same product rated differently on different platforms from low to medium, all the way up to just a blanket high that's been put on things. How is an advisor meant to delineate between that really broad range being applied to the same strategy?
Clare O'Hara: I'm just staying with you, Lindsey on that thought. We're talking about so many investment products that are out there, and so many different strategies coming out in the liquid alt space. Why should investors bother to learn each of these complex strategies?
Lindsay Holtz: Absolutely. It goes back to your portfolio objective. Back to the why, why are you doing this? Do you have a problem in your portfolio that you need a solution for? Some people are looking to decrease the risk in their portfolio. A lot of people that we talk to right now, we're trying to figure out how do you keep the same return that you've experienced for the last five years when you're looking at a market with ... That's late in the cycle with low bond yields, with increasing global debt. When you're faced with that, you say to yourself, it's pretty hard to create the same return profile that I've enjoyed of late without doing something different. As an investor, you need to choose. Am I going to accept lower returns, or am I going to do something different? I think the need to do something different, to continue to achieve your return targets within a reasonable risk band is a really good reason to start thinking about how liquid alternatives fit into your portfolio.
Clare O'Hara: Are there certain percentages that investors should be thinking about? How much of that should be the portfolio, is there a maximum amount that you shouldn't go above?
Lindsay Holtz: I think it all will come back to an individual investor's portfolio tolerances. Back to your basic advisor, are you a low risk or a high-risk client? I don't want to see people that don't understand these strategies, loading up in them just for the sake of loading up in them. On the other hand, to Dave's opening comments that you add a little bit of something that's different to your overall portfolio structure and you can really smooth out your return profile and create a higher quality return. I don't want to tell people that they should be 10% or 25%, because I think it is very specific to the client what they already have in their portfolio and what their overall objective is for that portfolio.
David Picton: Just to add onto that, that's an excellent point. Because really, if you just want the best return in the long run, you should just buy an equity base portfolio and just sit on it through thick and thin. I believe wholeheartedly that will be your best performing asset in the very long run. The part of it that's tricky is that through thick and thin part. Usually if you looked at the performance of say a mutual part.
Brooks Ritchey: At least thick part.
David Picton: You look at a mutual funds’ performance, and it might be X through time. If you look at the average performance of the holders in it, it is almost always dramatically lower. Why is that? Well, because when it's over here, they get a little bit panicky and they sell [inaudible 00:24:38], and then when it's over here they feel really good and they buy some more. They never enjoy this long-term return benefit. If someone is prepared with their risk tolerance to be all in inequities and to stick with it through thick and thin, maybe they don't need any of these in their portfolio. Maybe they're going to look for someone who actually makes their return stream even more powerful. If someone's not prepared to do that, and they know that their bond component is going to deliver them basically nothing over the next 10 years, and they're looking for something that maybe modulates the return, but still gives them a chance for high risk adjusted returns, then these things have to play a part in their education and in their portfolio solution.
Brooks Ritchey: I'd like to add some numbers, if I may.
Clare O'Hara: We love numbers.
Brooks Ritchey: It's absolutely correct. Every client profile, every advisor model, it depends on what you're trying to solve for. What are the concerns? I wouldn't call them portfolio issues, but what would cause pain to the investor over the next five years? I can tell you what a JP. Morgan survey came back with. They talk to seven or eight different investor types, Endowments, pensions, family offices, bank and brokerage platforms. The range of allocation was, the low end was 10% and the high end was 20 in the endowment model. Clearly the minimum could be zero, on the advisory model spectrum. If someone is young and has a long investment horizon, maybe they don't need something that is a diversifier. The first step is normally 5% allocation. Rent it before you buy it, try it. These are liquid. You buy it today you sell it Monday or tomorrow. The maximum I've seen in sitting with CIOs is a 25%.
Brooks Ritchey: They're very cautious on equities. I didn't want to tie back the question on allocation. How much allocation to something Lindsey said early on, and David degrees. These are diversifying strategies, but they are designed to make money. This is not like buying car insurance or life insurance, you know you're going to spend ... In the US, the average insurance premium is 3% of the value of the car. You know you're just going to spend 3% a year on your premium. These products do make money, are intended to make money and diversify.
David Picton: Critical point, they have to make money, otherwise there's no point.
Brooks Ritchey: Right. This is not a charity case. This is a positive influence diversifier.
Clare O'Hara: Just staying with you Brooks, we're talking about the growth of the alternatives market in the US has been very impressive. How are advisors using these investment strategies in their practice in the US, and do you expect to see similar trends moving to the Canadian market?
Brooks Ritchey: A couple of good statements and questions there. About three years ago, I was asked to travel to Asia and walk through the concept of liquid alternatives, and what we call hedged strategies and non-directional strategy. I thought okay, glad to help. I got there and I said, why such an increase in interest. They said, because our interest rates are zero. Japan in 2016, JGB yields went to zero. I thought that's a dilemma because in the old days, I think David mentioned this, you would de-risk by lightening up on equities and buy more government fixed income. Well, that's not so much an option and the Japanese were first over the line to lose that option. I said okay, think of hedge strategies as a very nice diversifier to fixed income. It actually is negatively correlated. Most hedge strategies are negatively correlated to bonds. If you don't like the bond market or you're not earning the yield, they really ought to look at something that's more alpha driven hedge strategy. I thought that's interesting. Glad to help. They bought hundreds of millions of dollars’ worth of hedge strategies.
Brooks Ritchey: Then about a year and a half ago, I get a call from ... True story, continental Europe, and they say, can you come over and explain to us how alternative strategies would fit in today's environment, and today's portfolios? I said, sure. Why the sudden interest? Because the ECB and the Swiss and ... They've taken rates to zero, negative 70 basis point interest rates, policy rates in Switzerland. That's a problem when you have to pay money to put your money in the bank. I said, I think I have a solution. I think I have something that'll help. We walked them through the, what we call conditional diversification. It helps protect when bonds are on the downside. Franklin Templeton, who bought K2 Advisers, the hedge fund division of Franklin Templeton, they launched a [inaudible 00:29:48] and a 40 Act mutual fund. The growth was phenomenal, so far so good.
Brooks Ritchey: Because the Asian investors, the continental European investors and more recently the North American investors, our 40 Act is seeing flows as I'm sure others are, because now it's a valid alternative. I'm trying to answer your question in that, the macroeconomic environment. The aging of most of investor base, the aging demographics, they have enough tech stocks. They made money in Apple. They're not earning interest on their bonds. Equities will do fine and bonds will do fine, but it's not going to return the 7, 8, 9, 10%. They're worried about the uncertainties in the market, and they're not earning any yield in cash. They're going to try this new product class. Thank goodness, it's working out so far. I do believe. I know that in Franklin Templeton, the products they launched in the alternative space were some of the fastest growing products since launch, since [C capital 00:30:55]. I'd like to see the same thing happened in Canada.
Brooks Ritchey: I think that, and I don't want to speak for the others, but this is a market environment. It's not risk on, it's not risk off. Its risk uncertainty but waiting for certainty on so many things. Maybe this is a place to park some money while we're waiting for higher yields or more clarity on Brexit, China, the Fed etc. cetera.
Brooks Ritchey: In our product class, trust me, David. I'll show you. I've got the math in my bag. I didn't know it till they told me. There's a very strong relationship between low rates and improved Alpha in hedge strategies.
Lindsay Holtz: I think if we fast forward a few years, because this is what we did see in the US. Is that, the tsunami of product, there's a ton of choice flows are going in and they're going to settle at those products that met their objectives, that performed. Because as we've said here, if there isn't performance, what's the point? I think, well, it's going to take some time for this to mature in Canada when we ... As we move from, this is a really neat new thing and people are throwing spaghetti at the wall, to actually seeing which products are meeting their objectives and the flows are going to shift into those investment led opportunities that actually are delivering what they promised.
David Picton: Unfortunately I 100% agree. The best flows that we saw at our firm were when we protected through the 2008 crisis and delivering on the objectives, and then the money came in after when people were de-risking, when they should have been risking.
Brooks Ritchey: Right, re risking.
David Picton: Hopefully that doesn't happen again where we do get tested, we do meet our objectives and then people flow in after the fact as opposed to getting prepared for something that may not be as pleasant as they might like.
Clare O'Hara: You are anticipating for growth.
David Picton: In the industry, absolutely, absolutely. There was such a need for portfolio diversification tools out there that absolutely that would-be growth regardless of how this plays out.
Brooks Ritchey: Especially given the interest rate and valuation environment today. Be careful out there. Its 10 years after the global financial crisis. Be very selective.
Clare O'Hara: When we look at the different markets, like you mentioned Europe and Japan, this is new in Canada and the regulators have taken a bit of time to prove this stuff. Maybe I can throw this at you David. Why did it take so long for Canada to catch up and how far behind do you think we are?
David Picton: I think it was mentioned earlier that when the industry started here, it was a go-go industry full of resource centric, highly leverage portfolios that performed dramatically well and then flamed out. Many of the early innovators in the space, they're no longer here. Then there was the odd little fraud thing that happened along the way, early days. Rightfully so, the regulators looked at this and said, we have to protect investors. Like pendulum shift, I think they protected too hard. Now, I think they're coming to the realization that this is a good product, if it's done by the right practitioners that can enhance a person's portfolio. Now they've come back to a happy medium.
David Picton: They haven't gotten as aggressive as they could either. They didn't want to go in this direction to now letting everything happen. I think they struck a really good compromise that allows reasonable leverage and reasonably diversified portfolios to enter into the discussion again.
Lindsay Holtz: The 60, 40 balanced, classic balanced portfolio, has served investors well for quite a number of years now. The demand from investors and from advisers for something different wasn't really there, because they could just ... It was a layup. You just put your money into some pretty classic strategies and you're meeting your objectives. That's changing, and that's why the timing coincidentally, but this is when they actually approve the rules lines up quite well for the type of environment that we have in front of us.
Brooks Ritchey: I don't think they're too late or too early. We read through the regulations as I'm sure everyone did. They seem quite responsible to have max leverage of three times. When you buy a house, you put 25% down payment and you borrow 75%, you're three, four to one leveraged in real estate. They were responsible with the regulations, and as long as people act responsibly, and there's no bad eggs, then look, transparency helps cure fraud regulations. Regulations help cure irresponsibility on leverage and liquidity. It's another investment option. Just like when real estate investment trusts were launched, or leverage ETFs were launched. Some of them are for enhanced return leverage CTFs, and some of them-Some of them or for diversification reasons. I would put us in that group.
David Picton: By the way just on that leverage point on housing, to me that's an example of bad leverage. You took an asset then you levered it up in the same direction four times.
Brooks Ritchey: Right.
David Picton: Whereas in our funds and your funds, what you're trying to do is lever in the opposite direction, so that you're removing some of the volatility if you will, within the process.
Brooks Ritchey: Good point. You buy your house and you sell short your neighbor's house.
David Picton: Exactly. Perfect.
Brooks Ritchey: In case the neighborhood-
David Picton: That's good leverage.
Brooks Ritchey: That's good leverage.
Clare O'Hara: Lindsay do you think the Canadian investor will embrace it as much as they have in the US, do you think we'll get there?
Lindsay Holtz: I think we will get there and I think that we can learn a lot from looking at our sophisticated institutions here in Canada. Many of whom have made this a strategic allocation in their portfolios. It's not something that they float in-and-out of. They have absolute return, liquid alternative strategies as a core holding in their overall portfolio and I think there's a lot we can learn from that and I think that the Canadian investors will get there.
David Picton: Actually they're already there. To Lindsey's point, we have some of the most sophisticated, most leverage, most illiquid pension plans offerings in the world, that protect most Canadians. Ironically their pensions are already managed in a lot of these kind of ways.
Lindsay Holtz: They're just unaware of it.
David Picton: They're unaware of it and maybe they should apply some of those thoughts to their actual savings as well.
Lindsay Holtz: It's also ... It's not to say we haven't had these products available to retail investors, it was just a higher standard in terms of who could go into them. They were a bit harder to buy. If you wanted to fill out a 30-page subscription document and you met all of the accredited investors tests, these types of products have been available to investors. What this has done is made it easier for everybody to participate.
Clare O'Hara: David, just a follow up. We've touched a little bit about this but if investment dealers have limits to the liquid alts in their portfolios. Where should advisers use that allocation, the liquid allocation budget, to equities, to fixed income and balanced?
David Picton: I think our industry has always tried to rail against the 6040 model. Lindsey mentioned earlier. 6040 has been amazing. The way I would use this allocation is, do I have too much rate sensitivity or do I have too much equity sensitivity. If I do, perhaps I could use one of these products to offset it. In other words, it's really going to depend on the individual investor. What their portfolio looks like and Brooks' point what sort of risk tolerance that they're prepared to go with. That advisor now plays a much more critical role than simply setting up the 6040 putting it on auto pilot. That advisor to me of the future shifts to what is the best portfolio that maximizes your quality returns for the given level of risk that you're prepared to take on. It's really good at differ dramatically depending on that tolerance that that individual has. The less tolerance ironically the more of these you should add.
David Picton: Even though the compliance guys will say this is the highest risk thing you're adding. Because the compliance people don't take into account how the product interacts with the rest of the portfolio. That's going to change over time.
Clare O'Hara: Brooks, do you agree?
Brooks Ritchey: Totally agree. If someone actually sat down and looked at ... I mentioned it earlier a conditional correlation. When the stock market comes under stress what does the bond ... The 40% do. When the 60% is catching a cold does the 40% help protect? Historically that's been great. Totally agree. If it was 6040 and go to the cottage, that would be fantastic. It feels like it's a different environment more recently and going forward what if the bonds don't protect your equities like they have in the past. When rates are low the bonds can't rally that much more unless they're going to go through 0. This is a third asset class that I think when you run the numbers on it and it's not super complicated when equities come under stress some hedge strategies do have a little bit of pressure, but when bonds come under stress the head strategies tend to more than compensate on the upside in performance. They're what we call a conditional diversifier.
Brooks Ritchey: You don't want of diversification benefit. I know they're going to agree with me on this. Everyone says I want to diversification, they're half right. They want to be correlated during a bull market in equities, but when equities go February 2018, 4th quarter 2018, now I want to versification well we have a word for that it's conditional diversification. A good head strategy, a good liquid alternative, it makes you know 30, 40, 50% of the upside in a bull market, and maybe it only loses 5, 10, 15% on a downside or in a perfect world goes up when equities come under stress. You see where we're going? When people see that in the proposals and in real time with daily pricing and daily liquidity, they'll have the aha moment. It happened in Asia, it happened in South Korea when they loosened up the regulations. Germany on head strategies, it's happened in the US. I think to their point we're either there or it's happening.
Brooks Ritchey: Because people will see another February or 4th quarter and they'll see, "Hey I didn't have to call David and yell at him. I didn't have to call Lindsey and yell at him." There were other asset classes that were more stressful.
Clare O'Hara: Lindsey, are there certain market conditions which would lead to a greater investor or advisor interests in this outside class?
Lindsay Holtz: I think it's we've talked about; the current market environment is actually quite ripe for investors to think about shifting some of their asset mix into liquid alternatives. Because what you don't want to do is make the mistake that Dave saw his investor make, where they come looking for the portfolio tools after the negative situation or the challenging market situation has happened. It's tough for investors to make that shift, because they've done okay in pretty traditional portfolios for recent number of years here. People aren't as focused on needing to make a change, because the numbers that they're seeing in their portfolios, continue to look pretty good. Excluding the most recent quarter that we've gone through here.
Lindsay Holtz: It's hard to convince people to change when the numbers haven't shown them that they need to change. Once the event has happened, it's too late. I think as you're looking at your portfolios today, and you're saying how I'm I going to continue to achieve that return objective that I'm looking for, you've got to bring some different tools into your tool box. Adding something that has some complexity associated with it doesn't mean it's more risky you just need to understand what that complexity is. Make sure that they have the operational infrastructure to manage through the additional tools that are being brought to bear. The shorting, the leverage, the use of derivatives, counterparty risk that comes through with that. Then I think another to answer that is back to the why. Why do you want to add this to your portfolio? I think different market environments may answer that why question may be different depending on different market environments.
David Picton: If I could add to that. Maybe another way of explaining these products and how they might work would be literally to go back to 1982. That was of the Paul Volcker era of trying to crush inflation expectations and a lot of people, especially older savers will remember paying 15, 16% on their mortgage rates maybe even higher trying to buy a house that was at that time incredibly cheap but still very difficult to carry. You have these massively high bond yields and you had depressed stock prices. Then we just had 37 years of that trend completely reverse. If you look at that 60-40 solution that Lindsay's referring to. Was it really incredible acumen by the investment committee that delivered on a really good promise or was it 37 years of interest rates falling that may have aided the portfolio. Because if you went to the 10 years before 1982 and you looked at 6040, that is not an appropriate solution for anybody.
David Picton: It did not work, it did not help with the exception of equities kept you a little bit in line with the pricing power erosion of inflation. I'm not saying we're ever going to get back to that but the environment we've been in, may be right for some change that Brooks alluded to earlier.
Brooks Ritchey: Risk uncertain, risk on for 37 years and bonds and stocks. I started in 1982 as well.
David Picton: Nice. So, you're winning?
Brooks Ritchey: Yeah. But it's not over till the third period. It's going to be interesting going forward. This is a, I don't know what to do type of product class. It's a conservative ... I like what Lindsay said, just complexity doesn't mean risky. The auto braking program on your car, so don't run into the car in front of you, that's very complex. All I know is it stops the car before you hit somebody. I don't need to understand it, I just need to know works. I think we're entering ... I agree with David. We're entering a period where maybe some other mix other than 6040 might be the way to go.
Clare O'Hara: Brooks just to look individually at each of your companies. Brooks Franklin Templeton recently launched a new fund. Can you give us a high-level overview of that fund and maybe why you think it differentiates itself from others in the category?
Brooks Ritchey: Sure. I don't know many of the other products as well as maybe some of the panel mates but on March 11th Franklin Templeton did join the Canadian liquid alternative trend and launch a daily liquid regular 81102 regulated product. It's actually somewhat interesting because I mentioned the different types of hedge strategies out there. Equity, long, short event driven. These are actually ... It's a fund made up of three trading programs that we manage in house. Rather than allocating money out to a hedge fund manager and paying them fees we save the investor fees and expenses by allocating to some trading programs that we've been running for years now for our institutional clients.
Brooks Ritchey: It's a bit different than maybe David and Lindsey's products. I don't know. It's a multi component fund, that's investing in three distinct hedged strategies. You're capturing alpha, you're protecting from bond and equity markets abut we're doing it in various in-house trading programs. One differentiator we're told by clients is that ... I don't know if you all have it. We have the ability, the three portfolio managers. Myself and two others, we have the ability to hedge out certain market risks at the product level. We've got the three trading programs that are managed by the portfolio managers. The master level PM team has the ability to say, "You know what were even more concerned about equities than that group is or that group is." So, we're going to hedge out some of the market risk with what we call a conditional risk overlay. I don't want to pitch the product too much, but any sort of alternative hedged strategy is something worth looking at.
Brooks Ritchey: Whether it's in house managed and offered in an 81102 format or whether it's a hedge fund allocation program. The key is controls, transparency, the pedigree of the teams running it and is it acting as advertised.
Clare O'Hara: Lindsay what gives your firm an edge when you're managing these liquid alternative investments.
Lindsay Holtz: Sure. We've been managing alternative investments for over 15 years. For both institutional investors and also individual investors. These are tools that our team is very experienced in using. We have proven track records in the types of products that we're bringing into market. When we looked out developing what we were going to bring into the 81102 framework we looked at the products we already had and we said let's not invent something new to bring in to try and convince individual investors to buy. Let's take a page out of the proven book of what institutional investors have come to us for. For well over a decade and let's make sure that that can be executed effectively, within the rules that are out there. We have an alternative Canadian equity, an alternative global equity product as well as an alternative fixed income product. All of those are drawing on tools and proven capabilities and proven track records that our team husband using in primarily an institutional framework but also with individual investors over time.
Lindsay Holtz: I think that just makes a really big difference. Because as we've talked about, the management of the complexity of these products, being able to bring that together with actually delivering a proven investment outcome, that's what's going to differentiate and those are going to be the products that stand above the others. Because performance at the end of the day is what we need to deliver to investors.
Clare O'Hara: David can you give us an overview of your dedicated team of professionals that are in this space?
David Picton: Sure. Well, first while we spent a massive amount of time on portfolio construction research. On the products that we launched, we wanted to make sure that we embodied the principles that we believe in within them. When we do multi-strat we know that people have stocks and bonds in their portfolio. We believe everybody should have those in their portfolio. But those are simply Beta tools. There's other betas you can add into better diversify even a 6040 model and improve its risk adjusted returns. Then we layered on some tactical timing around that and then focused on some different styles of investment that we think should be in the portfolio and then finally try to add in some alpha. Our investment team basically focuses on each of those different 4 layers of fortification if you will. We have 35 investment professionals and like my colleagues we all have some battle scars using these different products through time.
David Picton: Getting squeezed on shorts. Understanding when you're taking on risks that you may not be aware of in a portfolio. We have a very complicated risk process and a team that reports to or senior management committee. We have compliance that overviews things and then of course we have each other practitioners within those four layers of fortification.
Brooks Ritchey: You're a multi strategy, is that what I'm hearing?
David Picton: We have a multi strategy offering. Then we'd throw in a market neutral fund for the alpha component. Because I think that's missing in most portfolios, and then we'd throw in a momentum based 13030 product. We think that's also missing within most portfolios today.
Brooks Ritchey: Yeah. We're in the multi strategy category. Most investors start out with a multi strategy type of products, so that they're not making any big strategy bet. Then as they get comfortable and educated, they might tilt towards and equity alternative or a fixed income alternative.
Clare O'Hara: Just before we conclude, I want to maybe get final thoughts on for advisors who might have stepped into the space or they're just thinking about possibly adding it to a client's portfolios. Maybe some final thoughts on where they should start or an overview on what they can think about before adding it to a client's portfolio and I'll start with you David.
David Picton: I think they should really, really, really understand the hidden bets in their portfolio. As I said earlier, if I look at the traditional portfolio that I see in the Canadian context, it is highly, highly rate sensitive. Whether they believe that or not, there is a hidden interest rate bet they've taken. If they get to that level and then they start looking around, well, what am I going to use now in the new world of incredibly low interest rates and incredibly expensive stocks. What I'm I going to use as the building blocks for my portfolio. That should lead them into contemplating these different return streams that diversify their current existing portfolio. Then it's a matter of why a particular product, why this particular group and why this particular product and why do I need a right now in the mix and that'll help sort through the tsunami of buzz words and marketing brochures and phone calls you're going to get over the next, well probably years on these things.
Clare O'Hara: Brooks.
Brooks Ritchey: I know where I would start and I think it's quite simple. Most of the asset management firms have portfolio consultants or groups that will model in portfolio construction mix. It's simple, I would say do me a favor Mr. and Mrs. Advisor run my portfolio as it stands today and run it with 5, 10, 8% of one of the products or another. They just have to see for themselves how it takes the edges off. It takes the draw down; the losses reduce them. In some cases, it might a help performance much more than people expect. I just think every time I ask to educate ... I'm asked to educate on alternative and hedge strategies, I just pull up the before and the after. It's no different than a healthcare commercial. Here's what he looked like before and here's what he looks like now. It's very rare that it hurts, it's very common that it helps either on return to risk or on performance or both.
Clare O'Hara: Lindsey.
Lindsay Holtz: I think as an adviser you want to get yourself educated. Just as Brooks said that investment managers shouldn't be afraid of regulation, they should welcome it. We should also welcome the questions that come in to help people better understand what it is they're buying and what they're not buying and then go back to the question why that we keep asking. Why liquid alternatives, why now, what role does it need to play in your portfolio? Because once you answer those questions and once you educate yourself on how some of these different products work and demystify some of the complexity and the jargon that gets thrown around out there to really just get down to what is this product going to do and what is it going to do in my portfolio? You can make better decisions about what you're adding that might be complimentary, what you're adding that might be diversifying and what solution it is that you need, and work with the investment managers to help you understand all of those moving pieces.
Lindsay Holtz: So that you can confidently go back to your clients and really express why they should have this, not just become because it's the latest new thing that's out in the market.
Clare O'Hara: I'd like to thank you all for your participation today and for providing all of your thoughts and insights on such a complex and new topic for many of our advisors and investors. I'm Claire O'Hara with The Globe and Mail. Thank you for watching Asset TV's, liquid alternatives masterclass.