MASTERCLASS: Liquid Alts - November 2019

Diversification and asset allocation have been fundamental principles of sound financial planning and portfolio construction. Canadian regulators introduced rules that will allow portfolio managers and ultimately retail investors the ability to employ strategies that were previously restricted - such as leveraging and short-selling. Now Canadian markets and Canadian investors are looking to replicate the success seen in the U.S.

3 experts explore liquid alternatives and what amendments to national instrument 81-102 mean to Canadian advisors and their clients:

  • David Picton, President, CEO, Portfolio Manager, Picton Mahoney Asset Management
  • Andrew Torres, Founding Partner and Chief Executive Officer, Lawrence Park Asset Management
  • Myles Zyblock, Chief Investment Strategist, Dynamic Funds

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  • 53 mins 40 secs

Clare O’Hara: Canadian retail investors looking for hedge fund-like strategies are being inundated with new options, following a rule change that happened this past January.

Since then, the liquid alternatives category has grown exponentially, giving portfolio managers greater flexibility and alternative strategies, such as short-selling, leveraging, and derivatives.

Prior to January 2019, these alternative strategies were restricted to accredited or institutional investors only. But now the new rules are serving the retail client who are looking to seek returns that don't correlate directly with stocks and bonds.

Joining us today are three experts who are at the forefront of the conversation around liquid alternatives.

Joining me today is David Picton, President, CEO, and Portfolio Manager with Picton Mahoney Asset Management.

Myles Zyblock, Chief Investment Strategist with Dynamic Funds.

And Andrew Torres, Managing Partner at Lawrence Park Asset Management.

I'm Clare O'Hara of the Globe and Mail, and this is Asset TV's Liquid Alternatives Masterclass.

Good afternoon, gentlemen, thank you for joining me today. So, there's been a lot of buzz around liquid alts within the last year, and so I just want to dive into the questions today, and I'm going to start with you, Andrew, as mentioned.

It's been a year since liquid alts entered the Canadian marketplace. What's the reception been like so far?

Andrew Torres: We've actually been surprised how well the reception has gone. I think whenever you introduce a brand new asset class and it operates under a different set of rules, you expect that there's a period of education that needs to occur, there's going to be some skepticism. But I think Canadian advisers and investors are really willing to embrace the potential of this new asset class. We've seen a fairly good run in the markets, generally, with interest rates near all-time lows, equity markets near all-time highs, but certainly I think the more savvy investors are aware that we may be close to a turning point, and those who can begin to refine their portfolios and use some of these new tools, which are perhaps less directional than traditional markets or traditional products, might actually benefit them, should as in when that turn actually comes.

Myles Zyblock: I just want to say that to follow-up on the point that I wouldn't consider liquid alts to be a new asset class, I'd consider it to be a new asset class for retail Canadian investors. Liquid alt has been around for 30 plus years, but you're right, there is an education that needs to happen with the retail investment community, and I think a lot of different companies in Canada have been working hard at trying to educate investors about these tools and at least what we've felt, or we've experienced, we've experienced some pretty good success. I think the success has been a little greater than anticipated so early on.

Clare O’Hara: And David, what are your thoughts?

David Picton: I think there's a two-tier market. I think there are individuals that have used these in the past, they understand how they fit into a portfolio construction. They used them when they were in an offering memorandum form. They were tougher to buy, there was paperwork involved, but they understood the concept of using them correctly in a portfolio. The other side of the equation kind of shunned the class for a while because it was hectic and tough to use, and now they're starting to get up to speed, educationally.

So, I think there's really two kind of investor that are using it, or at least exploring it. One is there and the other is just starting to get their mind wrapped around it.

Andrew Torres: I'd echo that. We've certainly seen early adopters that have been happy and willing to jump in quickly. But even those that perhaps aren't as familiar or comfortable with some of these new trading concepts, they're at least recognizing that the barriers to entry are lower. There's less paperwork involved, typically it might carry a lower risk rating, and these make it an easier option to buy, especially when you factor in that there is daily liquidity.

So, if they decide they don't want it, it's pretty easy to change their mind.

Clare O’Hara: So that leads nicely into my next question, Myles, because I want to know, what are some of the performance characteristics you want to have in alternative asset strategy?

Myles Zyblock: So, alternative assets is this term that overhangs the market, and everyone goes, "What the heck is an alternative asset", right? That's the first question I get, "What do you mean by that"? And then I usually tell people that I'll start with confusing you, and an alternative asset, I say, is not a stock or a bond. It's not the traditional asset classes. And then people go, "Whoa, wait a second".

And then you have to sort of warm them up to the idea that it can be a function of different types of asset classes like currencies, commodities, real estate, or it can be strategies, right? Like equity long/short, credit long/short, et cetera.

The whole point is that these liquid alternatives have daily liquidity and they aren't stocks or bonds. Now there's been a lot of product out that's come out in the Canadian marketplace because of these regulatory changes this year, and what I think you really need to help people simplify what they're looking at.

So, I say that an alternative, a liquid alternative, should have low performance correlation with your traditional asset classes, like stocks and bonds, and should have some sort of positive expected return. And really, that's it. It's a diversifying tool. It's a new diversifying tool that aren't stocks or aren't bonds.

David Picton: Maybe another way of putting that is that these are not one vehicle. This is a set of tools that you could add into your portfolio, and the tools have all kinds of different characteristics and functions. Some are going to be highly aggressive; some are going to be highly conservative and hopefully uncorrelated. And some are going to be somewhere in between on this spectrum.

So that's the challenge of the investor or the adviser, is to understand which of these plethora of new tools actually suits the objective that they're trying to meet with their client base.

Clare O’Hara: Right. And Andrew, how are you explaining the performance characteristics?

Andrew Torres: Well, I think we're trying to educate investors to look at, as we've talked about, correlation. Look at expected volatility. I mean, oftentimes with some of these hedge fund strategies that are now being adapted to liquid alternatives, it's not the old style, shoot for the moon hedge funds. This is really about trying to hone in on specific risks and hedge away or mitigate a lot of the traditional risks that are sitting in bond and stock portfolios.

So, by bringing down the volatility, creating that more consistent return stream, bringing down the correlation to traditional strategies, you really can add it to a portfolio in a way that actually improves significantly the risk adjusted returns.

Clare O’Hara: Right. And so, Myles, can you walk us through the benefits and the allocation considerations for liquid alts, and explain why alternatives are not a hedging strategy, but rather a diversifier?

Myles Zyblock: So yeah, for me, a lot of people when they think... The first thing that investors when they hear liquid alternatives, they think it's a hedge to equity risk, for example. So, if the equity markets, the wheels are going to come off the equity market, I need to be in this liquid alt, because it's going to do better or go up, or whatever. And that's not true. It might be true for some liquid alts, but I think for most liquid alts, it's not true.

When you're finding low performance correlation with equities, all it means is that if equities go down, my alt could go up. Or down. Or sideways. That's the idea of low correlation. And that's what you want in your portfolio, and what you want from a liquid alt.

You don't get diversification benefits. The one thing I'd say is if you want a hedge to say equity risk, buy a put option in the S&P 500. I mean, that's a hedge. So liquid alts, to me, are a diversification tool, no different than an equity investor who looks at bonds to diversify their risk.

So that's kind of how I view it, yeah.

Andrew Torres: Sorry, I was just going to say that is a key consideration, especially when we live in a world where risks are becoming more and more correlated, generally. I mean, you look at the last 10 years and you can say, "Hey, bond markets and stock markets have both risen at the same time". Now that's been great for investors, but it also means that the opposite could be true, and we could see both markets going down at the same time. And it's actually getting harder and harder in a world where we have full globalization, to actually say that it's easy to find uncorrelated assets.

It can actually be quite difficult because when it's risks off, it's risks off, and it can hit every asset class. So, finding the strategies where the expected volatility, so that when things go down, they don't go down as far. Or the timing of the down and the up or the recovery period, perhaps, is quicker than it would be in traditional markets. Those can be really, really powerful additions to a portfolio.

David Picton: The way our firm likes to look at it, at Picton Mahoney our mission is to try and help investors reach their long-term objectives with more certainty. And so, we're trying to harness an idea that almost all investment professionals or portfolio builders use, they use this very powerful, simple concept. And that is that they have a stock portfolio and that they have a bond portfolio and they have both of those, because sometimes those two move like this, and that little interaction, that little diversification benefit, has meant that a 60/40 portfolio has had way better risk adjusted returns than an equity portfolio only or the lower return of a bond portfolio only.

So, let's take this idea of assets moving back and forth, and let's include other assets within that. And, as Myles said, you can use an asset like a commodity, or you could use a strategy like a market neutral fund, and you could find other tools that go like this.

And if you do that, you extend that simple tool that everybody uses, that risk adjusted return enhancer, and now you broaden out your ability to really take advantage of it.

Clare O’Hara: So, Andrew, I want to jump back to you for a second. We're talking about short-selling derivatives, leveraging, all these terms can really be daunting to the new retail investors. So how do you describe using these tools, and how do you maybe lessen the fears in some investors when they hear those types of phrases?

Andrew Torres: Well, this is a very important concept, because the ability to use this expanded set of tools is at the heart of liquid alternatives. When the Canadian regulator wanted to introduce this to Canada, as Myles says, this has been around in Europe and in the U.S. for many years, available to retail investors, but it's new to Canada. It's important when you're explaining your strategy that you don't shy away from the fact that it has these expanded tools. But it's important to articulate how you're going to use them, because it's one thing to say, "Hey, I could take this long/short strategy and I can take it from zero to 300 or to negative 100 and back again, and if I get the timing right, these returns are going to be awesome". But that's unrealistic, and it's ripe for both disappointment and, potentially, disaster.

So, what we try to do at Lawrence Park is really explain how we use those tools to substitute risk. To remove certain risks that we think do not offer sufficient reward for the amount of volatility that they represent, and then to enhance the attribution of return to those aspects that we think are particularly attractive in this type of market.

And by doing that, I think you're giving a very clear road map to how you incorporate these tools in a way that provides more consistency of returns and less directionality.

Clare O’Hara: So Myles, are you taking a similar approach?

Myles Zyblock: Well, it's part of the education process, right? So yes, I've been on the road a lot talking to advisors over the last eight, nine months, to try to educate them on this newish product. Again, not new idea, but newish product called liquid alts. And I think the education is very important because there has to be... With the education comes some sort of comfort level with what people are purchasing, and that's critical, I think.

The investor has to have trust in the process that's being purchased, so yeah.

Clare O’Hara: David?

David Picton: Part of the concern, if you will, part of the reason why it took so long for these things to come to Canada, all revolves around the real heart of the matter, which is called leverage. As soon as you put leverage into any kind of discussion, people back away. So, I like to think about it two ways. Two kinds of leverage.

There's a leverage that a household investor could understand. They put 10% down and they borrowed 90% from a bank, and they bought their house. They are highly levered real estate investors, and as long as their real estate price goes up, they will make a massive amount of money on the 10% that they put down. If it goes down, that 10% goes to zero, they've lost everything.

So, they use this leverage every single day, but they use it in something that they have to exist in, their home.

So, you can take that, and you can apply it to the stock market. You could buy a highly, you could put 10% down and you could lever your portfolio up and take a great big risk on something. That's bad leverage to us, and all of these gentlemen would agree with that, or you could use leverage that acts exactly the opposite to weigh your position.

In other words, I bought this stock and I did the exact opposite with another stock. I have "used leverage", but really, I've just removed a market risk from the portfolio. I've actually lessened the risk by doing it that way.

So, this leverage concept is really the heart of it. It's difficult because it looks scary if you do it this bad way. It's really powerful and risk-enhancing, risk reducing, if you use it in an offsetting way.

Clare O’Hara: Right. I do like your analogy of putting it back to their mortgage, because that's the thing most retail investors would have.

                                                            So just talking about transparency, which is another big topic around retail investors. So, when we talk about transparency of these funds, as advisors are often challenged to describe how the investment strategy is implemented, can you talk about how that factors in?

David Picton: Well, first of all, the prospectus framework that the new liquid alts are under puts way more constraints on a portfolio manager to do what they say they're going to do. Because it is outlined in a prospectus, and if you violate the prospectus, you could get yourself in a heap of trouble. And so that's a good thing.

The difficulty is then is that that prospectus can be very nebulously written and difficult to understand, and then you apply it to all kinds of different portfolio strategies, and suddenly this is where the confusion lies. So, you have to have a way of breaking down your particular solution, the way you manage this particular tool in a way that becomes very simple to follow and, in a way, that you've done it historically. So, you can show people the actual track record of this particular strategy.

That's the biggest challenge we have as an industry, because it is fairly brand new to a whole bunch of people coming into it.

Clare O’Hara: So Andrew, how are you approaching things, when we're talking about transparency of these funds?

Andrew Torres: I think we take the approach that investors of a certain level of sophistication and they deserve as much transparency as they want. I think the days of black box strategies are behind us, except with some very small exceptions. But really, for the everyday investor, the proof has to be in the pudding. You have to tell them what you're going to do, and then you have to do it.

I think a great example, and we'll go back to the leverage discussion from earlier, we have a strategy that involves the use of leverage when it comes to corporate bonds. And the way I describe it is I say, well I could buy a 10 year bond with no leverage or I could buy a two year bond or a three year bond and apply some leverage.

Now, I think everyone would agree that 10 year bonds tend to be more volatile in terms of price than two and three year bonds. So, if I can create a risk profile that's no different, or very similar, in terms of expected volatility to owning an unlevered 10 year bond, but now I'm doing it with short dated bonds with leverage. That is a way of enhancing the yield and giving me greater certainty over the expected future value.

So, you know within a period of two or three years that that bond is at a legal obligation to be paid back at par. That gives you some comfort over how volatile that strategy could be.

So, these are just examples, and when we describe that technique to investors then they just want to see. "Okay, show me that portfolio." And when I say, "Hey, here's our portfolio, it's 70% corporate bonds, investment grade under three years", they're like, "Okay. Now I understand, now I see you're doing what you say you do, and I have a better idea of how you're trying to deliver returns".

Clare O’Hara: And Myles, are you doing anything similar?

Myles Zyblock: Well, again, I think that it's all part of the education to disclose to your clients, and one of the things that helps with the whole transparency issue, and I think David alluded to it, is that you can show people how you've managed or navigated that particular strategy you're talking about through different market cycles or economic cycles.

So, I think a track record is part of that transparency process. Just to see if the manager at the helm controlling the wheel can do what he or she is saying they're doing.

Clare O’Hara: Great. So just to stay with you for a second, Myles. What is the appropriate allocation of alternatives to include in a client's portfolio? We always talk about how much should be in there.

Myles Zyblock: Yeah, it's a question we receive a lot, and I don't think there's one answer for every client, of course. But I can give you some ranges.

In the U.S., where these alts have been in the retail community a little longer, most retail investors have allocated about five to seven percent of their portfolios to liquid alts. Now you go to the institutional community, like pension funds, endowment funds, who have been using alternative types of strategies or assets for decades. In 1998, their allocation globally, pension funds was about seven percent to alternatives, broadly speaking, including liquid alternatives. Today, that seven percent has gone up to 30 percent.

So global pension funds find that it's maybe not a 60/40 anymore. It's a 40/30/30 or something like that, where 30 is the alternative ask.

Now again, this is a new field with many new products in Canada, and I wouldn't suggest anyone goes out, fills their portfolio with 30 percent full of alts. I think you have to start very small; you have to get comfortable with the strategy that you're investing in, you have to know why it's in your portfolio. Five-ish percent is not a bad start, anyway.

Clare O’Hara: David, do you agree with that?

David Picton: I think Myles touched on something that's critical, that each investor is going to have a certain risk tolerance in their portfolio. So, in the old days, a bond might have a variation of say four or five percent, a standard deviation is smooth, fairly stable, and then stocks might be 12 or 13. And the combination of those things might have been eight. And so, if you're comfortable with a traditional portfolio of around eight percent volatility, you could add in a huge amount of alternatives into that.

Especially considering that the bond component of your portfolio is probably going to generate close to zero returns, going forward. So, if I want to get a little bit better risk adjusted return, I'm prepared to tolerate an eight percent volatility level, I might add a huge amount of liquid alternatives into the mix.

If I'm prepared to just go all in on the equity market, which is probably going to be the best long-term returning asset class, and I'm prepared to take a massive volatility range in the way, I'm prepared to tolerate a... If you went back through history, an 80% downturn in the '30s or a 50% downturn a decade ago, or a couple of 40s, if I can stomach that, I should go a hundred percent into equities. And forget about everything else.

So, it really comes down to what would you like, as an investor? What would your ideal, be able to sleep at night, portfolio look like? And I think people are going to find over time that more alternatives as opposed to less should make up that mix.

Clare O’Hara: Andrew, your thoughts on that?

Andrew Torres: Yeah, well, first of all, I'd say I think we're a long way away from having to educate investors about what the maximum appropriate is. I think really what we're telling them right now is zero is too small.

But I think Myles' point earlier about what institutions are doing, they clearly in the last decade have embraced alternative strategies and alternative assets as a core part of their portfolio in a significant way.

And the reason the Canadian regulator has introduced liquid alternatives, and I think many of us in the industry would argue it's overdue, it's been a long time coming, they want that, if you like, democratization, of investment strategies. These vehicles that have been available to the highly sophisticated ultra-high net worth investors or institutions, need to be more readily available to everyone. So, that's the first thing.

And then the second thing is you can also... If the core alternatives should be a part of your everyday portfolio. It's not meant to be a tactical addition. However, having said that, we are sitting, as I said earlier, we are sitting at a point where we're in a very mature economic cycle, equities are sitting near all-time highs, interest rates are sitting near all-time lows. That's not a recipe for the next five years of returns to necessarily be that great from traditional asset classes.

So, I think the opportunity is there. The opportunity to diversify, the opportunity to lower volatility is there with some of these new products. As I've been hearing, experience is key, so find a manager who has demonstrated the ability to use these tools and in an effective way, can point to some sort of track record. But there shouldn't be a fear around using some of these tools, because some of them are actually quite intelligent use of risk and will definitely improve the risk adjusted returns of portfolios.

Clare O’Hara: So you touched upon a couple of things in my next question. We've mentioned, all of you have mentioned, that there's a lot of new funds coming to market. The last year we've seen a flood of them coming into, available for retail investors. But what are the most important things that an investor should consider when they're sitting down and saying, "I want to add this to my portfolio".

I'll jump back to you, Andrew, to start, because you touched upon a couple, like looking for good managers. What else should they look at?

Andrew Torres: I'll probably reiterate what I've said. First of all, experience, experience, experience. That's key. It's like you have... I think what we have here is we have alternative strategies that make use of these new set of rules, and the best position to do that from the portfolio management point of view are managers who have used those tools regularly in their existing strategies. That typically means hedge fund managers.

On the other side of it, you have mutual fund managers who have things like broad distribution, they offer the full transparency, they offer daily liquidity. They're used to dealing with many, many smaller investments coming in and out of the portfolio regularly.

So, the trick is, well how do you marry these two extremes of the business? Hedge fund managers just aren't used to dealing with some of those issues I was just mentioning. And so, I'm sure each of our respective firms have found our own solution, but I think absolutely critical is looking for experience and strategy. Look for that articulation of strategy that we were talking about, that you can explain clearly how you're using these new tools to create better risk adjusted returns, and then look for a firm or a distribution model where they can handle some of the operational issues, because if you don't get the operational issues right then, the fund is likely doomed to fail, good strategy or bad strategy.

So, it's important that you have a very strong distribution operational network involved with your fund, and it's important that you have a manager that can clearly articulate and point to a track record using these new tools.

Myles Zyblock: I just want to reiterate on the point is that one of the things that I really have been stressing that maybe not every other liquid alt manager has been stressing is the fact that you need to find the tools that have relatively low performance variability, performance correlation with traditional asset classes because just because a marketing department calls it an alt doesn't make it so.

So again, what is the real reason, why are we thinking about including these in portfolios? And it's really about diversification benefits of a lowly correlated assets. So, I think that is, outside of the track record, which I think is critical, and all the things you had mentioned, I think that it has to be something different than a stock or a bond. Or why buy it? You've already got easy access to stocks and bonds.

Clare O’Hara: So David, I want to touch upon something that Myles just mentioned, because it's true and for anyone else on the panel is that if everyone is marketing the name Alt, as retail investors look at this, how can they actually sift through and figure out if it's truly a liquid alt strategy and if they should be looking at it?

David Picton: This is our challenge. There is literally a tsunami of these products coming. We've got a number of funds that have one year track records now, so you can start to look at how did those funds perform through various points in time over the year. And, in fact, the last year has given us some interesting little test points. For instance, we had our market neutral strategy had its very best month in May, during the very worst month for the overall market. So, you could say, okay there was a benefit that they said they were going to have. Oh, there's a little bit of evidence. So, that's a starting point.

I think you start with three simple questions around why. Why do I need this particular product? If you can zero down to the benefit, like I am looking for a product that does this, and you can ask the provider, does this product aim to do this specific job. That's the first step.

Why you as a provider? Tell me about what kind of history you have in this. For instance, our firm had a fund that was up in 2008. Because we've been doing it for that long and we've shown that in those tough environments, we can deliver. Okay, maybe that's a bit of a plus.

And then, finally, why now? Why do I need this now? What does this timing objective that means I should start considering that right today as opposed to a year or two from now.

And if you start asking those why questions very soon, you will find this great big tsunami of names starts to kind of narrow down to just a simple couple of names to look at for your specific objective.

Andrew Torres: I want to touch on the why, the timing question again. I think one of the unfortunate byproducts of this 10 year bull market that we've been in is it's bred complacency, and you do hear from time to time when you're out meeting investors, I put money into this strategy or I put money into that strategy and I wish I had just kept it in the stock market, because it would have been better. Which is really the wrong way of thinking about it, because you have to look at what does it do during up markets, what does it do during flat markets, what does it do during down markets. And what you've heard repeatedly from us is all about diversification.

And I think what's going to happen ultimately is that there will be some sort of crash. There will be a 10, 15, 20% draw down in stocks, and it's only then that the investors that were forward-thinking and were adding some of these strategies to their portfolios will be glad they did, and the ones who didn't will be thinking, wow, I wish I had some of that.

So, going back to your earlier question, that's really what it's all about. It's not about how does it perform when the stock market's up 10%, it's about what kind of performance does it show in differing markets? Up, flat, down. And if you can point to a track record, as we've all talked about, if there's a clearly articulated strategy, if it's clear why this particular strategy shouldn't perform, just as some sort of mini-beta of the stock market, then you've got something that probably is worth considering for addition.

Clare O’Hara: So Andrew, I just want to expand, because you bring up a good point. The market's been hot for a while, we're all sort of anticipating changes to come. So how urgently should investors look to add this? Like, is this something they should be looking at immediate? This year? The end of 2019?

Andrew Torres: Every investment decision and every asset allocation decision should be made thoughtfully. It shouldn't be reactionary to what's happened last month, and it shouldn't be rushed into out of a sense of panic. So, I think what investors should be doing is doing the hard work now. Do the due diligence, meet with managers, start to understand the different strategies that are out there. Then you start to build, okay, how do I rank these three strategies from three different managers that look similar? How do I rank them against each other? What are the pros and cons of each one? So, do you have an approach so that you are comfortable and educated enough to make these additions?

But yes, why wait? Because as I said, market's near all-time high, interest rates near all-time lows. You've benefited from being in traditional assets for a long time now, but who's to say that's going to last? You're best suited to get going.

Myles Zyblock: Yeah, I just want to pick up on that. So, there's an issue about equity market volatility that's always in play, whether it's today, tomorrow, last week, next year. But I also think that when you stretch the horizon out, say, over the next decade and people have this expectation of what their portfolios are likely to generate, well you take the traditional 60/40 portfolio today, 40% of that portfolio is yielding less than one percent. Right?

Globally, the Barclays Global Aggregate is 0.7% there, 0.8%, maybe. So, you take the 10 year horizon, a 10 year bond yielding 0.8% or thereabouts, what's your return? You don't need forecasting, it's 0.8%. So that means a whole big whack of your portfolio isn't going to generate the returns that you have become accustomed to in the past, and perhaps there's the timing issues. It depends on the alt, of course, but there's also just yield enhancement, there's all sorts of different reasons why you might consider alts, and it doesn't have to be about timing. It's about just set it and forget it. It's about strategic asset allocation and diversification over the long term.

So, I think that, when is a good time to own alts? Anytime is a good time to own alts.

Clare O’Hara: David, do you have some thoughts on that?

David Picton: Yeah, I'll give you one very important reason to look at these things today. We've had the good fortune of analyzing a number of Canadian investor portfolios, and they started off with the best of intentions. They started off with 60% in equities and 40% in bonds. And slowly through time, just because of performance trends, they've accumulated this bond position where they keep adding managers that are income-related, bond fixed income, some sort of income sleeve within this bond portfolio, and slowly through time their equity portfolio has begun to look like a lot of dividend stocks, and a lot of high growth U.S. stocks. And the reality of that particular portfolio today it is, is incredibly interest-rate sensitive. More so, I believe, than at any point in time in history.

And that's fine. If we continue to believe that rates continue to go down, maybe we go to zero and then we go negative like in Europe and maybe we just keep going negative for some immense period of time. This is a great portfolio. If there is even a sliver of a chance that things change and maybe by some chance interest rates go up the odd time along the way, this portfolio is very ill-suited to that. And now you're looking at, what can I find that is uncorrelated or maybe even negatively correlated with what I have today? Because I am heavily bet on the whole interest rate horizon.

Andrew Torres: Actually, I can give you a great anecdote along those lines. My parents recently sold their house. They're in their 70s, and they had some liquidity, they wanted to put some money into the market. They approached an advisor, I won't name the firm or the advisor, but the recommended portfolio, which they received, my dad sent me to have a look at, the fixed income component, which was significant given their age, consisted of preferred shares and a 30 year high yield bond.

And I was floored that that was the type of advice they were getting, because those are not low-risk, low-volatility assets. And I look at the type of strategies that we come up with can deliver, and I know why the advisor has done it, because my parents are looking for that five percent income stream to fund their retirement, and the only way that the advisor could come up with to do it was to go into these riskier assets and call them fixed income.

And I know that these alternative strategies can deliver that with much greater clarity and much greater safety and much more consistent stream of returns than they're going to get from some of those traditional assets.

Clare O’Hara: Right. So, Myles, I just want to continue on the timing question, and we've touched upon this a bit, but I want to hear your view on the changing... We'll do that again.

So, Myles, I just want to continue a bit on the timing of the portfolio construction. So, I want to get your thoughts on your view on the changing macro-environment over the last decade plus, and the growing need for alternatives. We've talked a lot about it, but what are your thoughts on that?

Myles Zyblock: To reiterate what's been said by these gentlemen as well is that you have valuations, particularly in the U.S., that are near all-time highs in the equity market. And you have bond yields that are at 200 year lows. So, when you put those two together, what seems obvious to me is lower expected future returns out of the traditional asset classes, and higher volatility. So is there a case to be made for, like I said, alternatives, there's always a case to be made for one, but if there's a particularly interesting time to include alternatives in a portfolio, to diversify away from these traditional asset classes, it's now.

Clare O’Hara: So I want to sort of pivot a little bit here and talk about some specific strategies and David, I'm going to start with you. So what themes are emerging? What's popular, right now, in this space?

David Picton: We have two, actually, surprisingly good sellers so far. That would be our what we call Income Opportunities Product, and our Market Neutral Product. I think the reason they're doing so well is that the Income opportunities Product that we run tries to generate that hopeful goal of a five percent type return, but it takes on no interest rate risk to do that. And I think a lot of advisors appreciate the fact that most of the things they have in their portfolio have a lot of interest rate risk. It'd be nice to have something that didn't have very much.

On the Market Neutral side, just like Myles suggested, I would like to have something that maybe has no rate risk and no equity market risk, given the potential extremes both of those markets are at. The Market Neutral Fund can handily put together a return stream that does not have a correlation to those two assets. And so, I think those are what we've got people gravitating to.

The last thing is that we do have a multi-strategy product that tries to combine the traditional equity and bond beta, but also includes other interest rate diversifiers, such as commodities within it, and that's starting to garner some attention as well, but it's a newer product for us.

Clare O’Hara: And Myles, what are you seeing for popularity?

Myles Zyblock: It's actually been surprisingly good. We have four liquid alts that are out in the marketplace, equity long/short, credit long/short, basically enhanced options or yield-enhanced option strategy and traditional real estate and infrastructure, and the take-up for these four have been great. I think hats off to the managers behind them, because they've been doing this approach. This approach to investing has been going on with them for a long time.

Clare O’Hara: And Andrew, are you seeing anything similar or different?

Andrew Torres: Yeah, as I said, the uptake has been impressive. So, my company, Lawrence Park, is one of three managers for CI Financial, three alternative strategies they launched. They launched a longshore global equity fund, a tactical duration fixed income fund, and then our fund, which is an investment grade credit strategy. And all three have had their... What's interesting is that different advisors are using different funds to address specific risks in their portfolio or specific challenges in their portfolio. It's not like you're seeing a small number of advisors just saying, "Okay, I'll buy all three". They're actually being thoughtful about how these strategies fit in their portfolio objectives, and they're selecting the one that best suits their needs, which I think is very encouraging for the way forward.

Clare O’Hara: So David, what percentage of advisors would you say are using these for the first time, or putting them into clients for the first time?

David Picton: Oh boy, we've been doing this for a long time, and we've met a lot of advisors. I'm going to guess an estimate that approximately 20% of advisors, maybe, have used some sort of alternative fund through history. And they've kind of used it on and off, depending on how the market environment was. I'm going to guess now that we have a new 20% sleeve that's now contemplating the use of them.

Clare O’Hara: And Myles, just thinking about the 20%, and I'm sure it's going to be growing and I think you touched upon it, is there a certain strategy they should start with, or it's going to be all over?

Myles Zyblock: No, I wish it was that easy, where you could say this is your magic bullet. But you have to understand what they're trying to achieve with their portfolio and the targets and goals they're looking to achieve over time. And then you can sort of sit down and say, "Well I would focus on these two or three things", if it's about mitigating interest rate risk or if it's about a certain thing, it depends. Again, it depends on, I don't know what the right alt is for everyone, but I do know that alternatives themselves are tools that everyone can use.

Clare O’Hara: Great. So, I want to hear a little bit about questions and feedback that you might be hearing through the advisors, the investors. What are the queries that are coming back? What is maybe the pause button that's making them hesitate a little bit, or they need more information, going back to education? What typically comes up more often?

David Picton: Two things, I believe, really stand out to me. First of all, okay, I need to see some sort of track record. Now sometimes that's just an easy excuse to say, "Yeah, this is new, I'm going to look at it down the road, so I'll come back to you later on". But I think honestly, they want to see, okay, I need to see something that acts a little bit different when I need it.

The second thing is the major banks in Canada tend to put risk ratings on these products. And depending on the risk rating, it makes a dramatic difference in terms of their interest level. So when the regulator first changed the fund framework to allow for these assets, some of the banks immediately put high risk on all of them, it didn't matter what the solution was, it didn't matter what the track record of maybe the exact same solution that we've been running before, it's all high risk. And so that immediately puts a damper on the marketplace.

As the product season as the people that evaluate them with the banks get a little bit more understanding of the differences in the products, now you see those risk ratings come down, and immediately you see more willingness to explore them.

Clare O’Hara: And Myles, what are you hearing?

Myles Zyblock: I'm hearing many of the same things as David is. There's a lot of questions that sort of focus on the magic, too, like you alluded to, where what should I be buying and how much should I own? And I think that really is a function of what the advisor is trying to achieve with their clients. I can't answer that, but we can offer guidance, that's for sure, about helping them find some sort of solution with the alternative space that will work for them, for sure.

Clare O’Hara: And Andrew?

Andrew Torres: I would say that the most pressing need that we keep hearing, and perhaps it's because of the type of low volatility structure that we've been talking about, but the most pressing need I think is for low volatility income. As all these things that we've talked about, the fact that traditional bonds just aren't delivering enough yield in today's market, and as the demographics get older, then these investors can't afford the type of volatility that is prevalent in equities because, let's be frank, if they get a 20, 30% draw down, it can take 10 years to get back to the starting point. And that just doesn't work for today's investors.

So that's what's most pressing, but at the same time those same investors, that older demographic, they're the most conservative so their willingness or the willingness of an advisor to put these strategies into their portfolios, it can be a little bit daunting when they haven't seen these types of techniques before. So, it's really about gaining their trust, gaining their comfort. But I think the earlier point about the risk ratings that some of the major financial institutions, we're seeing them come down now. I think the banks have recognized that giving something a high risk rating when the strategy itself has a multi-year track record of delivering two percent volatility, it's just not consistent.

And so, we're seeing the banks make that move, step one. And I think step two will be for them to actually create models. So, the old style model of 60/40 or 70/30 or 50/50, depending on your age and risk tolerance, they need to be adapted to the new regime, the new reality, and incorporate some of these alternative strategies.

And I think if we see that, and I think it's coming, I think we're already seeing some of the banks begin to have a recommended list or to suggest portfolios and incorporate alternatives. That's really what the big step forward is, and that's going to make it a lot easier for both Canadian investors and their advisors to start adding these things to their portfolios.

David Picton: The good news about this whole situation is that the established kind of alternatives providers that have been around for a while, they've been doing, like we've been doing a lot of missionary work along the years, trying to educate people on why use these things. We recognize now there's going to be a whole bunch of new entrants, there's all kinds of noise. So, I think all the firms are now upping their game on education and portfolio construction education in particular.

At our firm, we've had six individuals working specifically on portfolio construction, allocation with the alternative fund framework for two full years now, so when they come to us, they're going to get not some buzzwords about risk adjusted returns and diversification benefit, they're going to get a full layout transparently delivered in terms of allocations and what sort of products you might consider in the mix, and our initial take up on it has been really, really well received.

Clare O’Hara: So David, I want to stay with you for a second. So, as an asset manager, is it easier from an investment management and operations perspective to go from running hedging strategies and offering memorandums to liquid alts or from running mutual funds to liquid alts?

David Picton: Well, I think we're all pretty biased on this answer, so I'm going to try to be a bit objective. Operationally, if you've been running a hedge fund and you have prime brokerage firms and you have different types of custodial relationships and you've been using borrowing facilities around the world to get stocks or bonds that you want to be long or short, from an operations perspective, I believe coming from the hedge fund community, it's way easier because these are exactly the same framework, but a little bit more restriction around them. So, to me, it's way easier to get up and running as a hedge fund manager, operationally.

There's lots that have been very smart investment managers, they could either be long only or they could be hedge fund related. So, I think in the next three to five years, it won't matter whether you were a hedge fund or a long only fund. I think in the short run, the traditional hedge fund guys have a bit of a leg up because they can point to track records. In five years, these guys will be pointing at track records as well.

Clare O’Hara: And Andrew, your thoughts on that?

Andrew Torres: Yeah, I'd echo some of what David said, although I do think that trading a long/short or a levered or a derivatives intensive strategy, that's a skill that's honed over a lifetime. I've been trading bonds and derivatives for 30 years and I've been through countless market shock events, Enron, Royal Com, Long-Term Capital, financial crisis. Some of these techniques that look great in quiet markets, in benign markets, they can act very differently when things are blowing up in a big way. Unless you're thinking ahead to, "How do you mitigate some of those risks", then who's to say? It's very easy for a long only manager to say, "Well, we've implemented this strategy and it's been working great, and here's our two year track record. We're just as good as anyone else". But I'd question whether they're really set up to deal with a major market disruption.

Clare O’Hara: So Myles, I want to turn some things over to... We talked a lot about education, that's a theme that came up a lot today. So, do you think the industry has had enough education? Do you think there needs to be more, is it a comfortable level? And if there is more, what else needs to be discussed?

Myles Zyblock: I think we have to keep reminding people, it's quite easy to forget the things I think we talked about earlier is, for example, the equity market is off to a hot start this year, and then everyone goes, "Well, why am I in this alt, because it's only up four, five, six percent". And you're going, "I just thought we went through the ideas of why you want to be in an alt. It's not an equity and it's not a bond. It's doing its own thing".

So, I think that constant reminder, until people become comfortable with the liquid alternative space, I think, will be here. Again, it's a very, very new area for Canadians, so no. I don't think enough education is... I think it's something we'll have to continue to remind people about the characteristics, qualities, and the benefits of. And some of the dangers of investing in liquid alternatives.

Clare O’Hara: And what are some of those dangers?

Myles Zyblock: Again, I think David maybe sort of roundabout touched on it is that when you have 40 plus new liquid alternative products come to market in a very short period of time, I'm not sure you can be, you're convinced that all of them are going to be able to deliver what they've promised. There's going to be a handful. It is a bit of a gold rush, but like I said, the way to mitigate that risk in your own portfolio is to do many things these gentlemen and I have suggested, is that focus on track records, focus on process, transparency, et cetera, et cetera, et cetera.

Clare O’Hara: David, do you want to add anything to the risks that are out there?

David Picton: Yeah, I mean what we definitely as an industry don't want to see is someone come along, promise this and then mismanage the leverage that we talked about earlier in a portfolio. So instead of it being risk diversifying, it was actually dramatically increasing the risk of the mix, and then create a black hole. That's the last thing you want to have happen in this industry.

And I kind of give the regulator credit for at least in the initial run slapping some fairly restrictive boundaries on these things, so that people had to be very aware of the risks. When you add leverage into anything, whether you're adding two securities instead of one into the mix, they can act differently, which is amazing. And sometimes they can go exactly against you on both sides, which is very painful, and we've all been through examples of that in the past.

And so, you learn over time how to manage that. If you haven't done it for a while, maybe you don't know how to manage that as well. We'll see. We'll see how it goes.

Clare O’Hara: So Andrew, any final thoughts on education or risk?

Andrew Torres: You know, it's still early days. The regulator, I think, did the right thing, which is to say, "Okay, we're putting the line in the sand. These are the limits that we'll set". But investors should be aware that it's not the be-all and end-all because firms are presenting the regulators with what they call exemptive relief letters where they ask for... I want to run a strategy this way, this is why I believe it will act in a way that's suitable for investors. This is why I'm not taking any undue risks, that it's still within the framework or the intended goals of the rule set. And the regulator is listening.

You've got, in some ways, it's a good time because as we talked about, the major financial institutions are sitting up and taking notice, and they're adapting. The regulator is sitting up and taking notice and adapting. The major fund creation companies are sitting up and taking notice.

Now it's a bit of a free for all, and that's where it gets a little bit messy. And when there is inevitably some type of market disruption event, there are going to be winners and there are going to be losers in the liquid alt space, just as there are in any other asset class. And it will take that type of coming of age, I think, in order to really start to differentiate in a way that will be ultimately beneficial for the whole industry.

But for now, I think that educating yourself and look for experience and look for that well-articulated strategy.

Clare O’Hara: So Myles, can you give us some final thoughts on what we can expect from this market in the next year, coming ahead?

Myles Zyblock: I think that it's only just beginning, if you go back to the early stages of passive investing or ETFs, you had a long runway. And now that's a very large part of the market. I think if the institutional money managers, like pensions, are any indication of where this thing is going to be going, liquid alts are not going away and they could end up being a very large share of a portfolio for most Canadians.

So, I think there's a big runway, but again, it's early stages. I think it's going to take some time, but I'm pretty optimistic about it.

Andrew Torres: The key thing is liquid alternatives aren't going away. This is not a flash in the pan fad. I really do think this will maybe revolutionize is too strong a word, but it will certainly upgrade the investment management industry for the next 10, 15, 20 years in a way that, at a time when I think, as we all agree, traditional asset class returns are going to be hard to come by.

Clare O’Hara: And David, final thoughts on today's topic?

David Picton: The irony is amazing to me, of this situation, because most Canadians, in fact almost all Canadians, have exposure to a couple of the most sophisticated alternative fund managers in the entire world. These are the ones that run their pensions that they rely on, whether it's as a teacher or whether it's an average Canadian getting Canada Pension Plan. So, they are used to these things in their portfolios, they just don't really realize it. Our job is now to make sure that their excess savings get the same kind of treatment over time. And if they believe in that concept, I think the industry is poised for a pretty good move.

Clare O’Hara: Great. I'd like to thank you all for joining me today and giving your expertise on this new space for advisors, and I'm Clare O'Hara with the Globe and Mail and this has been Asset TV's Masterclass on Liquid Alternatives.