A liquid alternative fund is a type of alternative mutual fund or exchange-traded fund available to Canadian retail investors. These funds employ hedge fund-like strategies, such as short-selling and the use of derivatives, but are packaged within the familiar and regulated structure of a mutual fund or ETF. They emerged in Canada following regulatory changes in early 2019, designed to provide easier access to alternative investment strategies. For Canadian investors, liquid alternatives offer a tool for portfolio diversification, potential downside protection, and exposure to returns that may have low correlation with traditional stock and bond markets.
Definition and Core Characteristics
A liquid alternative fund is an investment product that provides access to alternative investment strategies within a liquid, daily-traded structure like a mutual fund or ETF. These strategies are alternatives to traditional long-only investments in stocks, bonds, or cash. The core characteristic of a liquid alternative is its use of sophisticated techniques historically associated with hedge funds, including short selling, leverage, and derivatives. The term 'liquid' refers to the daily liquidity offered to investors, contrasting with traditional alternative investments like private equity or direct real estate, which often have lock-up periods. In Canada, these products are formally categorized and regulated as alternative mutual funds. They are designed to be accessible to the average retail investor without the high minimum investment thresholds typically associated with hedge funds. The investment objective is often to provide returns that are not closely tied to the movements of conventional equity and fixed income markets.
Liquid alternatives are distinct from traditional mutual funds in several key operational ways. They are permitted to use investment strategies and asset classes that are not allowed for conventional mutual funds under National Instrument 81-102. This includes the ability to sell securities short, meaning they can profit from a decline in a security's price. They can also employ leverage to a much greater degree, primarily through the use of derivative instruments like options, futures, forwards, and swaps. The regulatory framework allows these funds to create leverage up to 300 percent of the fund's net asset value. Furthermore, they may borrow cash, but only up to an amount equal to 50 percent of their net asset value and solely from entities that qualify as investment fund lenders. This combination of strategies aims to achieve specific outcomes like absolute returns, low correlation, or downside protection, which are different from the relative return objectives of most traditional funds.
Regulatory History and Market Development
The Canadian liquid alternative market was catalyzed by a significant regulatory change. In January 2019, amendments to National Instrument 81-102 Investment Funds came into effect, creating a new framework for alternative mutual funds. This rule change explicitly permitted mutual funds to use a wider array of strategies, including short selling and increased leverage through derivatives, which were previously restricted or unavailable. The new framework established specific guardrails, such as limits on borrowing and leverage, to manage risk within these more complex products. Following this regulatory shift, the market experienced rapid growth as asset managers launched new funds to meet investor demand. By 2021, investors had allocated over 21 billion dollars into approximately 150 liquid alternative funds. Despite this growth, liquid alternatives still represent a small segment of the overall mutual fund landscape, accounting for only about one percent of the total 1.88 trillion dollars in mutual fund assets under management in Canada. This suggests there is significant potential for further expansion as awareness and adoption increase among investors and financial advisors.
The evolution of the market can be traced through key milestones and the entry of major asset managers. The regulatory change in early 2019 is the foundational event that enabled the creation of prospectus-qualified alternative mutual funds for the retail market. In the years following, firms like CI Global Asset Management, TD Asset Management, and Fidelity actively developed and marketed liquid alternative products to financial advisors and their clients. The growth was driven by a desire from investors for tools to manage volatile markets and seek diversification beyond traditional assets. The market now includes a wide variety of strategies, from long/short equity to managed futures, offered through both mutual fund and ETF wrappers. This development mirrors a longer-term trend where institutional investors, such as pension plans, have steadily increased their allocations to alternative assets, and liquid alts bring a version of that institutional approach to individual investors.
How Liquid Alternative Funds Work
Liquid alternative funds operate by employing specific investment strategies that differentiate them from traditional funds. Portfolio managers conduct in-depth research, combining data-driven analysis with strategic judgment to make investment decisions. A common strategy is the long/short equity approach, where a manager simultaneously buys stocks believed to be undervalued and sells short stocks believed to be overvalued. This strategy aims to generate returns from stock selection on both the upside and the downside, while potentially reducing overall portfolio volatility. Other strategies include market neutral, which seeks to profit from price discrepancies while hedging out broad market risk, and global macro, which makes bets on economic trends across countries. These funds are permitted to use leverage, often created through derivatives like futures and swaps, to amplify exposure. The regulatory limit for leverage in these funds is up to 300 percent of the fund's net asset value. They may also borrow cash, but only up to an amount equal to 50 percent of their net asset value and solely from entities that qualify as investment fund lenders. This use of leverage and complex instruments amplifies both the potential for return and the risk of loss.
The internal mechanics of a fund can be illustrated by specific examples from provider literature. The SEI Liquid Alternative Fund's objective is to provide long-term capital appreciation primarily through investment in derivative instruments. It seeks to approximate the returns of a model portfolio of hedge funds, known as a Composite. This Composite consists of two main sleeves: a multi-strategy sleeve and a managed futures sleeve. The fund generally expects to maintain an approximate 60 percent weighting to the multi-strategy sleeve and 40 percent to the managed futures sleeve. The managed futures sleeve uses derivatives designed to reflect the return profile of an index of 20 large managed futures funds. The multi-strategy sleeve seeks to approximate the average return of the 50 largest hedge funds, excluding managed futures funds. This structure demonstrates how a single liquid alt fund can provide exposure to a broad basket of underlying alternative strategies through a synthetic, derivative-based approach.
Primary Strategies and Fund Examples
Canadian liquid alternative funds encompass a variety of strategies, each with a distinct objective. Long/short equity is among the most prevalent, designed to profit from both rising and falling stock prices. Market neutral strategies aim for returns uncorrelated to market direction by balancing long and short positions. Global macro funds take positions based on top-down analysis of global economic and political trends. Managed futures strategies trade in futures contracts across commodities, currencies, and financial instruments based on systematic models. Multi-strategy funds combine several alternative approaches within a single portfolio for broader diversification. Major Canadian asset managers offer a range of these products. CI Global Asset Management provides funds like the CI Alternative North American Opportunities Fund and the CI Auspice Alternative Diversified Corporate Class. TD Asset Management offers strategies such as the TD Alternative Commodities Pool and the TD Alternative Risk Focused Pool. SEI Investments Canada Company manages the SEI Liquid Alternative Fund, which seeks to approximate the returns of a model portfolio of hedge fund strategies. Fidelity Canada also markets liquid alternative strategies to investors seeking diversification tools for their portfolios.
Providers often highlight the specific assets and approaches within their strategies to illustrate their alternative nature. TD Asset Management's alternative investments include real assets like infrastructure and real estate. Their infrastructure portfolio includes assets like Rabbalshede Kraft, a pan-European renewable energy platform of onshore wind farms. Since its acquisition in early 2017, the operating platform grew by nearly 70 percent, from 8 projects representing 190 megawatts to 13 projects representing 317 megawatts. In real estate, TD's portfolio includes significant commercial properties such as office towers at Yonge and St. Clair in Toronto, comprising about 1.2 million square feet of space, and the Telus Garden office complex in Vancouver, a 500,000 square foot development with a 99 percent lease rate. These examples show how liquid alternative funds can provide exposure to private market asset classes like infrastructure and real estate, which have long-term contracts and predictable income streams, through a public fund structure.
Risks, Costs, and Investor Considerations
Investing in liquid alternative funds involves distinct risks and costs that differ from traditional mutual funds. The use of leverage and derivatives can magnify losses, meaning these funds may have a heightened risk of investment loss compared to a traditional fund. The complex strategies may not perform as intended, especially during certain market conditions, and past performance is not a guarantee of future results. While designed for diversification, these funds do not eliminate the risk of loss entirely. Fee structures are also a key consideration. Liquid alternative funds typically carry higher management fees than traditional mutual funds. This is partly due to the complex active management required and the common use of performance fees, where the manager earns an additional fee if the fund exceeds a certain benchmark. These fees can significantly impact net returns over time. Investors must also consider the specific risks of the underlying strategy, such as the risk of short selling, where losses can be theoretically unlimited if the borrowed security's price rises, or the counterparty risk associated with derivative contracts.
Before investing, Canadians should carefully evaluate several specific factors related to these products. It is crucial to understand the fund's strategy, its objective, and how it plans to achieve returns in different market environments. Investors should review the fund's prospectus in detail, as it contains mandatory disclosures about risks, fees, and the investment process. Assessing the experience and track record of the portfolio management team is important, though history offers no guarantees. The fee structure requires particular scrutiny, as high fees can be a drag on performance. Consulting with a qualified financial advisor is strongly recommended to determine if a liquid alternative fund fits within an individual's overall financial plan, risk tolerance, and asset allocation. The advisor can help interpret the complex strategy and explain its potential role. Finally, investors should remember these are not capital-guaranteed products, their values change frequently, and they are subject to the risks inherent in their specific strategies and the use of leverage.
- Leverage Risk: Funds can use derivatives to create leverage up to 300% of NAV, amplifying potential losses.
- Strategy Risk: Complex strategies like short-selling or global macro may not perform as intended in all market conditions.
- Fee Risk: Funds often have higher management fees and may charge performance fees, reducing net returns.
- Liquidity Risk: While the fund itself is liquid, underlying holdings or derivatives may be less liquid in stressed markets.
- Counterparty Risk: The use of derivatives exposes the fund to the risk that the other party to the contract may default.
- Regulatory Risk: The rules governing alternative mutual funds, such as NI 81-102, could change, affecting fund operations.
Role in a Canadian Investment Portfolio
For Canadian investors, liquid alternatives are primarily considered a tool for portfolio diversification and risk management. They are often described as a potential third pillar alongside traditional stocks and bonds. Because their returns tend to have a low or negative correlation to equity and fixed income markets, adding a small allocation can help reduce overall portfolio volatility. A core proposed benefit is downside protection. Historically, alternative strategies have tended to lose less during significant market downturns, though this is not a guarantee. These funds can also provide access to return streams and asset classes, such as certain commodities or volatility, that are difficult to access through conventional investments. Financial advisors may recommend them to clients seeking growth and stable returns, new opportunities, and forward-thinking expertise. They are positioned as a way for individual investors to gain some of the diversification benefits that major institutional investors, like pension plans, have long achieved through alternative assets. The appropriate allocation depends entirely on an individual's investment goals, time horizon, and risk tolerance.
The stated benefits of incorporating liquid alternatives into a portfolio are multi-faceted. Proponents cite diversification as the primary advantage, as these funds invest in assets or use strategies that behave differently than stocks and bonds. This can lead to a smoother investment experience by reducing portfolio volatility. Downside protection is another key benefit, as strategies like long/short or market neutral are designed to limit losses during market declines. Some strategies offer inflation protection, as investments in real assets like commodities or infrastructure may hold their value when prices rise. They can also provide steady, non-correlated returns, which can enhance the risk-adjusted returns of a traditional balanced portfolio. For example, the TD Alternative Commodities Pool offers exposure to commodities with low correlation to equity and fixed income markets, which can improve diversification. The TD Alternative Risk Focused Pool is a multi-asset solution designed to outperform its benchmark across various market conditions by combining alternative and traditional strategies.
- Diversification: Provides exposure to return sources with low correlation to traditional stocks and bonds.
- Downside Protection: Strategies can be designed to limit losses during market downturns.
- Inflation Protection: Certain strategies, like those investing in real assets, may hedge against rising prices.
- Access to New Opportunities: Opens up hedge fund-type strategies and asset classes to retail investors.
- Portfolio Stabilization: Aims to reduce overall portfolio volatility and improve risk-adjusted returns.
- Institutional Approach: Allows individual investors to mimic the alternative allocations of large pension plans.
Comparison with Traditional Investments and Hedge Funds
Understanding liquid alternatives requires comparing them to both traditional mutual funds and traditional hedge funds. Compared to a standard Canadian equity or bond mutual fund, liquid alts have greater flexibility in strategy. Traditional funds are generally long-only, meaning they buy securities expecting them to rise in value. Liquid alternatives can short securities, use substantial leverage via derivatives, and invest in a wider range of assets. This leads to a different risk and return profile. Traditional funds are often benchmarked against an index, while liquid alts may have an absolute return target or seek specific outcomes like low volatility. On the fee side, traditional mutual funds typically charge a management fee based on assets under management, while liquid alts often add performance fees on top of a base management fee. Compared to traditional hedge funds, the key distinctions are accessibility and liquidity. Hedge funds are typically offered only to accredited investors, have high minimum investments, and may impose lock-up periods restricting redemptions. Liquid alternative funds are sold via a prospectus to the general public, have lower minimums, and offer daily liquidity, allowing investors to buy or sell on any business day.
The regulatory framework creates a hybrid product that sits between these two worlds. Liquid alternatives bring hedge fund strategies into the regulated mutual fund environment, which imposes important investor protections. These include rules on custody of assets, independent oversight by a board of directors or independent review committee, and strict limits on leverage and borrowing. Hedge funds operate under different, often more flexible, regulatory regimes. The liquidity feature is fundamental. It means investors are not locked into their investment for years, as can be the case with private equity or some hedge funds. However, this daily liquidity requirement also constrains the fund manager, who must ensure the portfolio remains liquid enough to meet potential redemptions. This can limit the types of illiquid private assets a liquid alt fund can hold directly, which is why many use derivatives to gain synthetic exposure. In essence, liquid alternatives aim to deliver the best of both worlds: the strategic flexibility and diversification of alternatives with the accessibility, transparency, and liquidity of a traditional mutual fund.
Future Outlook and Industry Perspective
The future of liquid alternatives in Canada appears poised for continued growth, though it faces challenges. The market has expanded rapidly from a standing start in 2019 to over 21 billion dollars in assets, yet it still represents only a tiny fraction of the overall mutual fund universe. This indicates a significant runway for asset gathering if investor and advisor education improves. Industry participants believe these products meet a genuine need for tools to manage volatility and seek returns in a low-yield environment. The evolving alternatives landscape suggests more innovation in fund strategies and structures, including a continued shift towards ETF wrappers for their tax efficiency and trading flexibility. However, growth may be tempered by the complexity of the products and the higher fees, which can be a barrier for some investors. The performance of these funds through a full market cycle will be critical to broader adoption. If they demonstrably provide the promised diversification and downside protection during a sustained bear market, investor interest will likely increase. Conversely, poor performance or high-profile failures could stall growth. The industry's focus is on demonstrating the value proposition clearly and ensuring advisors are equipped to explain the role of liquid alts within a comprehensive financial plan.
From an industry perspective, liquid alternatives represent a strategic opportunity for asset managers. They offer a way to deploy capital with more flexibility than traditional mutual funds, allowing for innovative strategies. For hedge fund managers, launching a liquid alt version of a strategy is a way to access the vast retail investor market previously out of reach. The operational considerations for launching these funds are significant, involving robust derivative trading platforms, risk management systems, and compliance with the specific rules of NI 81-102. The market is also seeing the integration of liquid alts into broader investment solutions. Advisors can allocate to funds like the SEI Liquid Alternative Fund within their own portfolios or through a selection of asset allocation funds and portfolio models managed by firms like SEI Investments Canada Company. This makes it easier for investors to gain exposure as part of a pre-built, diversified portfolio. As the market matures, competition will likely increase, potentially putting pressure on fees and leading to more product differentiation.
Frequently asked questions
What are the main risks of investing in liquid alts?
The main risks include the use of leverage and derivatives, which can amplify losses. The complex strategies may not perform as expected, and the funds can be more volatile than traditional investments. They also typically charge higher fees, including potential performance fees, which reduce net returns. There is no guarantee of downside protection, and investors can lose money.
What are some common liquid alternative strategies?
Common strategies include long short equity, where managers buy and short sell stocks simultaneously. Market neutral strategies aim to hedge out market risk. Global macro strategies are based on economic trends. Managed futures strategies trade futures contracts systematically. Multi strategy funds combine several of these approaches within one fund for broader diversification.
What is a liquid alternative fund?
A liquid alternative fund is an alternative mutual fund or ETF that uses hedge fund type strategies like short selling or derivatives to target different outcomes. These funds combine the flexibility of hedge fund strategies with the liquidity and regulatory guardrails of a traditional mutual fund, making them accessible in a liquid structure. They are designed to offer new strategies to help manage risk or seek returns in different market conditions, acting as a third pillar in a portfolio alongside traditional stocks and bonds. Popular strategies include long short, market neutral, and global macro. Their goal is to provide diversification and potential downside protection with returns that may not correlate directly with traditional markets.
When did liquid alternatives become available in Canada?
Liquid alternatives became widely available to Canadian investors in early 2019 following regulatory changes. The new National Instrument 81 102 rule created a formal framework for alternative mutual funds, also known as liquid alternative investments. This regulatory shift allowed Canadian retail investors access to funds employing strategies that were previously more restricted. Since this change, the liquid alternative market in Canada has seen rapid growth, with investors allocating over 21 billion dollars to approximately 150 funds. However, these funds still represent only about 1 percent of the total mutual fund assets under management in Canada, indicating significant potential for further growth.
How are liquid alternative funds different from hedge funds?
Liquid alternative funds differ from traditional hedge funds primarily in their structure, accessibility, and regulation. Liquid alternatives are offered in a familiar mutual fund or ETF format with daily liquidity and are sold via a prospectus to the general public, requiring lower minimum investments. They operate within the specific regulatory framework for Canadian alternative mutual funds. In contrast, traditional hedge funds are typically offered only to accredited or institutional investors, may have lock up periods, and often operate under a different, less restrictive regulatory regime. Liquid alternatives aim to bring hedge fund like strategies, such as the ability to use leverage and derivatives, into a more accessible and transparent vehicle for average investors.
Why would someone add liquid alternatives to their portfolio?
Investors add liquid alternatives to their portfolio primarily for diversification, downside protection, and to seek returns in various market conditions. These funds use different tools and techniques compared to traditional equity or fixed income investments, which can help manage risk. Because they tend to have low to negative correlation with standard stock and bond markets, they can help reduce overall portfolio volatility and provide a cushion during market downturns. They act as a strong addition to traditional balanced portfolios, offering the potential for capital appreciation while improving diversification. Institutions like pension plans have increased allocations to alternatives for these benefits, and liquid alternatives now allow individual investors to access a similar institutional approach to portfolio construction.
Sources and further reading
- Liquid Alternative Investments, TDAM td.com
- Considerations for Alternative Asset managers. | Article gbm.scotiabank.com
- Liquid alternatives explained: Your top questions, answered fidelity.ca
- Liquid Alternative Investments | CI Global Asset Management cifinancial.com
- Liquid Alternative Fund seic.com
This article explains how things work and is not financial, tax or legal advice. Rules, limits and rates change, so check the current figures with the Canada Revenue Agency, your province or your financial institution before you act.