Alternative Investments: Benefits, Risks, And Structure PDF

Alternative Investments: Benefits, Risks, and Structure 20 CHAPTER OVERVIEW In this chapter you will learn about alternative investments, including hedge funds and alternative mutual funds. You will learn about the benefit...

Alternative Investments: Benefits, Risks, and Structure 20 CHAPTER OVERVIEW In this chapter you will learn about alternative investments, including hedge funds and alternative mutual funds. You will learn about the benefits and risks of investing in these types of products, and you will learn the structure of alternative investments and how they differ from conventional mutual funds. LEARNING OBJECTIVES CONTENT AREAS 1 | Explain what an alternative investment is. Introduction to Alternative Investments 2 | Identify the main categories and sub- categories that comprise the alternative investment universe. 3 | Discuss the benefits of adding alternative Investing in Alternatives – Benefits and Risks investments to a portfolio. 4 | Describe the risks of investing in alternatives. 5 | Describe the main structural features of hedge Alternative Investment Structures funds, alternative mutual funds, fund of hedge funds, and ETFs. 6 | Describe the similarities and differences Comparing Alternative Mutual Funds with between alternative mutual funds, hedge Conventional Mutual Funds and Hedge Funds funds, and conventional mutual funds. © CANADIAN SECURITIES INSTITUTE 20 2 CANADIAN SECURITIES COURSE      VOLUME 2 KEY TERMS Key terms are defined in the Glossary and appear in bold text in the chapter. accredited investor hedge fund accredited investor exemption high-water mark alternative investment hurdle rate alternative assets minimum investment exemption alternative mutual fund offering memorandum drawdown offering memorandum exemption efficient frontier operational risk first-order risk product transparency fund of hedge funds second-order risk © CANADIAN SECURITIES INSTITUTE  CHAPTER 20      ALTERNATIVE INVESTMENTS: BENEFITS, RISKS, AND STRUCTURE 20 3 INTRODUCTION Hedge funds have been a popular alternative investment vehicle for many years. Historically, they have been available only to high-net worth and institutional investors. Retail investors in Canada have had very limited opportunities to gain access to the strategies employed by hedge funds through closed-end funds and commodity pools. However, the October 2018 regulatory approval of alternative mutual funds, a new type of mutual fund that employs alternative strategies, expanded the retail investor’s access to these strategies. Based on assets under management, alternative strategies constitute a significant portion of the alternative investment universe. More importantly, they constitute the vast majority of the assets under management in the alternative mutual fund market. In this chapter, we discuss the characteristics of hedge funds and alternative mutual funds. You will learn how these managed products are structured and regulated. INTRODUCTION TO ALTERNATIVE INVESTMENTS 1 | Explain what an alternative investment is. 2 | Identify the main categories and sub-categories that comprise the alternative investment universe. Alternative strategies are categorized both by type of strategy and by the type of structure. Generally, alternative strategies can be found in exempt market alternative funds (i.e., hedge funds), alternative mutual funds (also known as liquid alts), exchange-traded funds (ETFs), and closed-end funds. WHAT ARE ALTERNATIVE INVESTMENTS? Alternative investments are asset classes that are different from the traditional three broad asset classes of equities, bonds, and cash. Although there is no standard definition nor definitive list of alternative investments, they are generally categorized for portfolio management analysis into three groups: alternative strategy funds alternative assets (i.e., real assets held directly or indirectly such as commodities, real estate, and collectibles) private equity We describe the main strategies of alternative strategy funds below, and, throughout this chapter and the next, we provide comprehensive explanations of these strategies. We also give brief descriptions of alternative assets and private equity in this section. ALTERNATIVE STRATEGY FUNDS Alternative strategy funds have fewer or no regulatory restrictions on the use of short selling, leverage, and derivatives, in contrast to conventional mutual funds. Generally, they also have greater flexibility to invest in illiquid investments. By using these strategies and products, managers are able to generate risk and return results that can be substantially different from those found in conventional funds using bonds and stocks. The same holds true even when the alternative fund and the conventional fund use the same bonds and stocks in their strategies. © CANADIAN SECURITIES INSTITUTE 20 4 CANADIAN SECURITIES COURSE      VOLUME 2 The funds’ strategies fall into any of three general groups: Relative value Relative value strategies attempt to profit by exploiting discrepancies in the pricing of related stocks, bonds, or derivatives. Event-driven Event-driven strategies maintain positions in companies currently or prospectively involved in corporate transactions including mergers, consolidations, restructurings, tender offers, shareholder buybacks, and other capital adjustments. Directional Directional strategies attempt to profit from anticipated movements in the prices of assets such as bonds, equities, foreign currencies, and commodities. Within these groups there are various sub-groups, which are covered in the next chapter. ALTERNATIVE ASSETS Alternative assets are real assets held directly or indirectly. They have risk-reward characteristics that differ from those of traditional, long-only stock and bond portfolios. The common types of alternative assets are as follows: Commodities Commodities are the basic homogenous materials produced and consumed by the world’s economies. Some commodities are used mainly for consumption, in which case the commodity eventually becomes a product that is consumed. Others are used primarily for investment purposes. Commodities can be accessed using the derivatives markets or by holding them in their physical form. The types of commodities that underlie major world markets include agricultural products, precious and industrial metals, and energy products. Studies, including the famous Ibbotson study, have shown that commodities exhibit low or negative correlation to traditional asset classes and have a positive correlation with inflation. These characteristics support the idea that commodities can exhibit real, inflation- adjusted returns. Real estate Real estate refers to land or any of the fixed assets built on it, such as buildings, houses, or factories. Real estate is considered an alternative investment even though it is one of the oldest investment classes. The real estate market is segmented into commercial, industrial, and residential sectors. Real estate becomes a liquid investment when it is securitized – that is, when shares in a pool of real estate assets, called a real estate investment trust (REIT), are resold to investors. Physical real estate and securitized real estate are two key forms of real estate as an investment. Many investors hold physical real estate in the form of primary or secondary residences or as investment properties. Collectibles Collectibles are rare and unique manufactured or handcrafted objects that are desirable to individuals. They include fine art, classic automobiles, rare stamps, and coins. Investing in fine art is traditionally the realm of the high-net-worth world. It has long consisted of building a collection and leaving it in a will as an inheritance or a saleable asset. © CANADIAN SECURITIES INSTITUTE  CHAPTER 20      ALTERNATIVE INVESTMENTS: BENEFITS, RISKS, AND STRUCTURE 20 5 Infrastructure Infrastructure investment is an investment opportunity that has gained the interest of both investment managers and investors. Infrastructure refers to such projects as roads, ports, airports, and water works. Over time, infrastructure deteriorates, and the need arises to repair or replace aging structures and to build new projects. Infrastructure needs have increased dramatically because of globalization and the growing middle class in non-Western nations. Investments in infrastructure typically entail massive amounts of capital with a small number of investing partners. Natural resources Natural resources include timberland and farmland. Farmland investors typically enter into agreements with tenant farmers to manage the day–to-day operations of the farm. The investor earns a return on investment from the ongoing sale of crops and, ultimately, through appreciation of the land’s value. Farmland investments can be accessed privately through private funds, mutual funds, hedge funds, ETFs, REITs, and publicly traded corporations. Timberland in recent years has proven to be a popular alternative investment due to strong ongoing global demand, moderate volatility, and low correlation with other asset classes. Over time, timber assets controlled by timber investment management organizations (TIMOs) have increased. A number of ETFs have surfaced to facilitate easy access to publicly traded TIMOs that have substantial timber exposure. PRIVATE EQUITY Private equity includes the common stock, preferred stock, and debt securities of firms that typically are not publicly traded, though an increasing number of private equity companies are listing on stock exchanges and their shares are publicly traded. Private equity investments may include leveraged buyouts, growth capital, turnaround investments, venture capital, mezzanine financing, and the purchase of distressed debt. Private equity is covered in greater detail in Chapter 22. INVESTING IN ALTERNATIVES – BENEFITS AND RISKS 3 | Discuss the benefits of adding alternative investments to a portfolio. 4 | Describe the risks of investing in alternatives. There are three main reasons why investors would include alternative investments in their portfolio, including diversification, adding alpha, and increasing absolute returns. WHY INVEST IN ALTERNATIVE INVESTMENTS? Three main reasons why investors would include alternative investments in their portfolio are summarized below: To diversify the portfolio Diversification incrementally decreases risk at a faster rate than returns incrementally decrease. To add alpha Alpha is added by incrementally increasing risk-adjusted returns. To increase the This, in turn, makes the portfolio more resistant to capital erosion in the market. portfolio’s absolute return nature © CANADIAN SECURITIES INSTITUTE 20 6 CANADIAN SECURITIES COURSE      VOLUME 2 Note that the term risk in this context refers to both volatility risk, as measured by standard deviation, and drawdown amount. Both are discussed in the next chapter. DIVERSIFICATION Efficient diversification is a hallmark of well-constructed portfolios. Most investors have some degree of diversification within their balanced portfolios. However, even a traditionally balanced portfolio can come under stress and must be re-evaluated in periods of stock and bond market volatility. A vast myriad of investments with various risk exposures are available in the alternative investment marketplace. These investments can exhibit low or even negative betas with traditional stocks or bonds and thus can add a level of diversification to an investor’s overall portfolio. Diversification with alternative investments can deliver the following benefits to the investors: Reduced volatility through a more stable net asset value (NAV) for the overall portfolio Downside protection in periods of market stress through reduced drawdowns Greater allowance for leverage, which can offer higher expected returns DID YOU KNOW? A well-diversified portfolio carries with it less risk and therefore is able to safely take on more leverage relative to portfolios that are poorly diversified. ADDING ALPHA As indicated in Chapter 15, alpha is a measure of the manager’s performance. If it is positive, the manager has produced more return than was predicted by his or her beta calculation, which indicates that the manager has added value to the portfolio. The greater the alpha, the more value the manager added, and therefore the better they have performed. On the other hand, an alpha value of zero indicates the manager has achieved only normal performance, meaning that they have added nothing to the portfolio’s value beyond its beta. If alpha is negative, the manager has underperformed for the level of risk taken on. Alternative investment funds can attract highly skilled managers because of their pay-for-performance compensation structure (discussed later in this chapter). As well, these funds are able to use strategies like short selling, leverage, and products such as derivatives that are limited or unavailable to conventional mutual fund managers. Additionally, alternative managers generally have greater flexibility with respect to investing in less liquid securities, such as private equity, real estate and distressed securities. Given their expertise and the strategies and investments available to them, alternative managers are generally able to produce higher risk-adjusted returns relative to conventional managers. They are able to do so regardless of the type of strategy employed. Of course, the strategies they use to achieve their objectives differ from conventional strategies. The strategies employed by alternative managers are covered extensively in Chapter 21. Alternative investments allow the investor to move to a higher efficient frontier (see next section) by increasing the number of investment opportunities available, increasing portfolio diversification and risk control, and adding superior risk- return potential to the portfolio. Also, many alternative investments target absolute returns, which means they aim to produce positive returns regardless of market direction. EFFICIENT FRONTIER One of an investor’s most important decisions to make is the asset allocation or asset mix decision. Studies have shown that between 40% and 90% of a portfolio’s volatility can be explained by the asset allocation, rather than security selection. © CANADIAN SECURITIES INSTITUTE  CHAPTER 20      ALTERNATIVE INVESTMENTS: BENEFITS, RISKS, AND STRUCTURE 20 7 Modern portfolio theory provides the tool to make the asset allocation decision. By combining various asset classes such as cash, bonds, equities, and non-correlated alternative investments, an investor can construct an efficient portfolio that maximizes the expected return for each level of risk in a combined portfolio. The various asset classes can be diversified further through market capitalization, geographic variations, duration, credit quality, currencies, and so forth. The curve that reflects the most efficient portfolios for all levels of risk is called the efficient frontier. All points below the efficient frontier are inefficient in the sense that by moving a portfolio up to the frontier, either risk can be reduced for a similar return potential or return potential can be increased for a similar level of risk. The efficient frontier is normally shown on a graph and is composed of combinations of assets that combine the lowest level of risk with the highest expected return at that level of risk. Standard deviation, representing risk levels, is measured along the x-axis. Expected portfolio return is measured along the y-axis. In Figure 20.1, Portfolio A represents a portfolio of 100% bonds in line with its relatively low potential return and low level of risk. Portfolio X represents the combination of two assets available (bonds and equities) that produces the highest rate of return with the lowest level of risk. Portfolio B represents the highest risk-highest return potential attainable, for example, a portfolio of 100% aggressive equities. Figure 20.1 | Efficient Frontier B Expected Return X A Risk (Standard Deviation σ) Many conservative investors believe that the safest, least risky portfolio would be 100% bonds, represented by Portfolio A. However, the graph shows that Portfolio X, which in this example consists of 20% stocks and 80% bonds, is superior, because it has lower risk as well as a higher return potential than Portfolio A. Portfolio X’s higher return potential is due to its stock component, which raises the expected portfolio return. Therefore, Portfolio A, while representing a possible asset mix, is not on the efficient frontier. Even though stocks are generally considered riskier than bonds, the fact that stocks have a relatively low correlation with bonds lowers the overall risk of a portfolio with this combination. However, if the portfolio contains more than 20% stocks, the higher risk of the stocks added will overwhelm the benefits of diversification and increase overall portfolio risk, along with the expected returns. Conservative investors who have avoided stocks could therefore benefit from some stock exposure. If stocks exhibit low correlation to bonds, they can actually lower the risk and potentially increase the return of the combined portfolio, because of the beneficial interaction of two assets with a correlation of less than +1. The same argument can be applied to alternative investments. By adding an asset class with a low correlation to stocks and bonds, a new frontier is created. © CANADIAN SECURITIES INSTITUTE 20 8 CANADIAN SECURITIES COURSE      VOLUME 2 As Figure 20.2 shows, by adding this asset class, a new efficient frontier is created that, at a minimum, gives investors the opportunity to increase their expected return without increasing risk, or to maintain their expected return at a lower level of risk. The efficient frontier with, for example, hedge funds is preferable to the efficient frontier without hedge funds, because it offers additional portfolio diversification possibilities. Figure 20.2 | Efficient Frontier with Hedge Funds Efficient Frontier with Hedge Funds Expected Return Efficient Frontier Risk (Standard Deviation σ) THE EFFICIENT FRONTIER How well do you know the efficient frontier? Complete the online learning activity to assess your knowledge. EMPIRICAL EVIDENCE Although there is variance between the different alternative strategies over the past 15 years until the end of 2019, they have generally outperformed traditional investments when traditional investments were performing poorly, such as during the 2004 – 2012 period. Conversely, hedge funds performed relatively poorly when traditional investments were performing very well during the 2013 – 2019 period. However, and perhaps more importantly, hedge funds performed very well, relatively speaking, during times of extreme stress in the traditional markets. This was especially true between 2008 and 2010 and during the first half of 2020. This fact reveals the ability of hedge funds to reduce overall portfolio risk by stabilizing the portfolio’s overall NAV. Hedge funds also provide some degree of downside protection to the portfolio’s NAV, particularly during periods when traditional investments are under extreme stress. WHAT IS RISK? When investment professionals refer to risk, they must contend with several popular measures. This is applicable when examining both traditional (long only) investment strategies and alternative investment strategies. Unfortunately, no single risk measure is perfect. Each risk measure must be utilized with a good understanding of its underlying assumptions and therefore limitations. © CANADIAN SECURITIES INSTITUTE  CHAPTER 20      ALTERNATIVE INVESTMENTS: BENEFITS, RISKS, AND STRUCTURE 20 9 The most frequently used measure of investment risk for alternative investment strategies is volatility as measured by standard deviation. It is used in two portfolio management applications: 1. Deciding on portfolio allocation to alternative investments utilizing an efficient frontier (discussed immediately above), and 2. When calculating risk-adjusted return measures such as the Sharpe ratio, first introduced in Chapter 16 of this course. The second most popular measure of investment risk used for alternative investments is the fund’s drawdown amount. The drawdown amount is essentially the maximum percentage decline in the alternative fund’s NAV over a specified time period. Drawdown amount will be discussed in more detail later in this course. ALTERNATIVE STRATEGY RISK DRIVERS There are a number of sources of risk involved in alternative strategy funds, all of which are described below. However, alternative mutual fund regulations have limited some of the first- and second-order risks in comparison to hedge funds. In this section, we explain the differences between first-order risk (or directional risk) and second-order risk (such as liquidity risk, default risk, and leverage risk). We also discuss operational risk (or business risk), which is a third category of risk not specifically related to the alternative strategy fund’s strategies. The terms first-order risk and second-order risk are used to classify risks related to an alternative strategy fund’s investments and trading processes. These risks directly affect such a fund’s overall risk and return. FIRST-ORDER RISKS First-order risks relate to the exposure to changes in the general direction of equity, fixed income, currency, and commodity markets. The source of risk is the market itself, and the risk is systematic, meaning that it cannot be reduced through diversification. First-order risk does not affect relative value strategies or event-driven strategies to any significant degree. It does, however, affect directional strategies, which, by definition, are based on an alternative strategy fund manager’s views about the direction of different markets, interest rates, commodity prices, and currencies. SECOND-ORDER RISKS Second-order risks include liquidity, leverage, deal break, default, counterparty, trading, concentration, pricing model, and trading model risks. Unlike first-order risk, these risks are not related to the market, but to other aspects of trading, such as dealing, implementing arbitrage structures, and pricing illiquid or infrequently valued securities. Second-order risks are defined in Table 20.1. Table 20.1 | Definition of the Second-Order Risks Second-Order Risk Definition Nature of Risk Liquidity risk The risk that the manager will be To unwind illiquid positions quickly, alternative unable to unwind a position quickly strategy funds may be forced to accept prices and at a price close to the most that are significantly different from the most recent price recent prices. Alternatively, it may take a fund manager some time to unwind illiquid positions at fair prices. © CANADIAN SECURITIES INSTITUTE 20 10 CANADIAN SECURITIES COURSE      VOLUME 2 Table 20.1 | Definition of the Second-Order Risks Second-Order Risk Definition Nature of Risk Leverage risk The risk of loss on a position All else being equal, higher leverage results in financed with borrowed money higher risk because it magnifies both upside and downside returns. Leverage is not inherent in any strategy. The decision to use leverage is a choice made by the alternative strategy fund manager. Deal breakage risk The risk of loss from the failure Merger arbitrage funds specialize in taking of two companies to complete positions based on expected deals or mergers an announced merger between companies. The strategy may result in losses if the merger is not completed as expected. Default risk The risk that the issuer of a debt Debt securities represent contractual security will not meet its obligations obligations to pay interest and principal. related to the payment of either or Losses can result if an issuer defaults on both the interest and principal these obligations. Counterparty risk The risk that the counterparty Over-the-counter agreements are private to an over-the-counter (OTC) transactions between two counterparties. agreement will not fulfill its Alternative strategy funds may suffer losses obligations. if the counterparty to an OTC agreement does not fulfill its obligations. Trading risk The risk of receiving a poor fill Unexpected delays in getting an order price based on unexpected delays filled may result in a price that is worse in execution than expected. Concentration risk The risk of loss from an adverse The higher the concentration of a single change in the price of a position position or security in a portfolio, the greater with a relatively large weight in the risk to the portfolio of an adverse event the portfolio that affects the security. Pricing model risk The risk that the output of a pricing Many hedge funds value their complex or model is incorrect because the illiquid positions using a model rather than assumptions on which the model a market price. These models are based on is based are incorrect assumptions, which can lead to erroneous valuations if the assumptions are incorrect. Trading model risk The risk of loss related to the failure Some alternative strategy fund managers base of systematic trading models in the their trading decisions on a systematic model current market environment that was tested on historical data. Losses may result if these models are unsuccessful in real time. © CANADIAN SECURITIES INSTITUTE  CHAPTER 20      ALTERNATIVE INVESTMENTS: BENEFITS, RISKS, AND STRUCTURE 20 11 OPERATIONAL RISK Operational risk relates to the alternative strategy fund as a business entity. It stems from the fact that alternative strategy funds can be small, newly created businesses that depend on one or more high-profile managers for their success. Such organizations are highly focused on promoting and supporting the skills of the manager or managers. However, they may lack the organizational depth, managerial talent, and strategic planning capabilities necessary to ensure growth, or even survival. For most alternative strategy funds, operational risk stems from potential system failures, as well as faulty settlement, reporting, and accounting procedures. Operational risk is significant and must be addressed through due diligence. ALTERNATIVE INVESTMENT STRUCTURES 5 | Describe the main structural features of hedge funds, alternative mutual funds, fund of hedge funds, and ETFs. For Canadian investors there are different ways to gain access to alternative strategies; hedge funds, liquid alternatives, ETFs and closed-end funds. The types of strategies they use can be similar. However, there are significant differences in their product features and regulatory restrictions and requirements for distribution to investors. The following sections focus on hedge funds, liquid alternatives, funds of hedge funds, and ETFs. Closed- end funds are covered in greater detail in Chapter 22. EXEMPT MARKET ALTERNATIVE FUNDS (HEDGE FUNDS) Hedge funds are lightly regulated pools of capital with managers that have great flexibility in their investment strategies. In Canada, as in many other countries, hedge fund managers are not constrained by the rules that apply to standard mutual funds. They can take large short positions, use leverage and derivatives for speculation, perform arbitrage transactions (which exploit perceived price differentials to make a profit), and invest in almost any situation in any market where they see an opportunity to achieve positive returns. Because a hedge fund manager has tremendous flexibility in the types of investment strategies he or she can employ, their ability to select superior investments within the targeted strategy and relevant markets is more important for hedge funds than for almost any other managed product. Despite the name, some funds do not hedge their positions at all. It is best to think of a hedge fund as a type of fund structure, rather than a particular investment strategy. Hedge funds do not have a unique legal structure (they may be structured as trusts or limited partnerships, for example) and their investment objectives and investor suitability vary depending on the manager’s choice of strategy and the targeted risk-return level. Some hedge funds are conservative, while others are more aggressive. The recent regulatory changes in Canada permitting the inclusion of alternative investment strategies under modified mutual fund regulations does not impact alternative investment products offered under existing regulatory exemptions for exempt/accredited investors and the minimum initial investment exemption (i.e., hedge funds). Private placement product structures are, and will likely remain, as the primary type of investment vehicle for both institutional and high-net-worth investors who are comfortable investing through limited partnerships. WHO CAN INVEST IN HEDGE FUNDS? Securities regulators permit the sale of securities without a prospectus, but only under certain conditions and only to investors who meet exempt investor qualifications. The exempt market is composed of both institutional investors and individual investors. © CANADIAN SECURITIES INSTITUTE 20 12 CANADIAN SECURITIES COURSE      VOLUME 2 There are three common prospectus exemptions allowed by the security regulators. Minimum investment exemption; Accredited investor exemption; Offering memorandum exemption. Typically, hedge fund investors who are individuals must qualify under the accredited investor exemption. MINIMUM INVESTMENT EXEMPTION The minimum investment exemption allows the sale of securities without a prospectus to non-individual investors who make a prescribed minimum investment. National Instrument 45-106 (NI 45-106) sets this minimum at $150,000 across all jurisdictions in Canada. ACCREDITED INVESTOR EXEMPTION The securities commissions apply different criteria for qualification as accredited investors by institutional investors and individual investors. The key qualifications for the two are as follows: Institutional Generally includes entities such as pension funds, trust companies and corporations with net assets of at least $5 million. Individuals An individual who, either alone or with a spouse, beneficially owns financial assets with an aggregate realizable value (before taxes, but net of related liabilities) that exceeds $1 million. Financial assets would include cash, deposits, bonds, and public equities, but would not include real estate. An individual whose net income before taxes exceeded $200,000 (or exceeded $300,000 if combined with a spouse’s income) in each of the two most recent years, and who has a reasonable expectation of exceeding that same income level in the current year. An individual who, alone or with a spouse, has net assets (which would include real estate, and which is again net of any related liabilities) worth at least $5 million. Persons relying on the accredited investor exemption to distribute securities to this type of investor must obtain a completed and signed risk acknowledgement form from the individual accredited investor. OFFERING MEMORANDUM EXEMPTION If an issuer prepares an offering memorandum in the prescribed form and it is delivered to the purchaser before the purchase, a prospectus is not required. The offering memorandum must follow a prescribed form and provide for the rights of rescission or a right of action, if these are not available by regulation. Included in the expected prescribed disclosure is information regarding the issuer and audited financial statements. In some provinces and territories (Manitoba, Northwest Territories, Nunavut, P.E.I., and Yukon), the offering memorandum exemption is subject to a limit of $10,000, unless the purchaser is an eligible investor. In other provinces (Alberta, New Brunswick, Nova Scotia, Ontario, Quebec and Saskatchewan) the exemption is subject to similar monetary limits as noted below and also subject to an overall purchase limit on an annual (preceding 12 months) basis (i.e., the amounts noted below must not have been exceeded over the last 12 months in order for the exemption to apply): In the case of a purchaser that is not an eligible investor, $10,000; In the case of a purchaser that is an eligible investor, $30,000; and © CANADIAN SECURITIES INSTITUTE  CHAPTER 20      ALTERNATIVE INVESTMENTS: BENEFITS, RISKS, AND STRUCTURE 20 13 In the case of a purchaser that is an eligible investor and that received advice from a portfolio manager, investment dealer or exempt market dealer that the investment in question is suitable, $100,000. An eligible investor has a lower financial threshold than an accredited investor but requires a confirmation of suitability from an eligibility advisor who is a registered investment dealer. HEDGE FUND FEATURES Hedge funds have unique features in their structure that other investment funds do not have. Some of those unique features are described below. INCENTIVE FEES In addition to management and administration fees, hedge fund managers often charge an incentive fee based on performance. Incentive fees are usually calculated after management fees and expenses are deducted, rather than on the gross return earned by the manager. This detail can make a significant difference in the net return earned by investors. Incentive fees are designed to attract top money managers and then to provide them with an incentive to perform well. Some investors, however, see a risk with incentive fees in that managers may be driven by self interest rather than the interest of the fund. For example, managers with no investment stake in the fund they are managing have only upside return potential and no downside risk (outside of not earning their performance fee). In that position, they may be tempted to take riskier bets. The calculation of incentive fees can be subject to a high-water mark or a hurdle rate, or both. These two measurements are defined below. High-water mark A high-water mark ensures that a fund manager is paid an incentive fee only on net new profits. Basically, a high-water mark sets a bar (based on the fund’s previous high value) above which the manager earns incentive fees. This feature prevents the manager from double-dipping on incentive fees following periods of poor performance. For example, suppose a new hedge fund is launched with a NAV per unit of $10. At the end of the first year, the fund’s NAV per unit rises to $12. For the first year, the manager is paid an incentive fee based on this 20% performance. By the end of the second year, the fund’s NAV per unit has fallen to $11. The fund manager is paid no incentive fee for the second year and will not be eligible to receive an incentive fee until the fund’s NAV per unit rises above $12. See Figure 20.3 below. It is important to determine whether the high-water mark is perpetual over the fund’s life, or whether the manager has the authority to reset the level annually. Hurdle rate A hurdle rate is the rate a hedge fund must earn before its manager is paid an incentive fee. For example, if a fund has a hurdle rate of 5%, and the fund earns 20% for the year, incentive fees will be based only on the 15% return above the hurdle rate, subject to any high-water mark. Hurdle rates are usually based on short-term interest rates. © CANADIAN SECURITIES INSTITUTE 20 14 CANADIAN SECURITIES COURSE      VOLUME 2 Figure 20.3 | Fund Performance for Investor (Rate of Return on Initial Investment − %) 20% New High Water Mark 15% Manager collects High Water Mark performance fee on gain 10% Manager 5% collects performance fee Value of Initial on gain Below high water Investment mark: no performance fee -5% Below high water -10% mark: no performance fee -15% -20% Year 1 Year 2 Year 3 Year 4 Note: Shaded regions represent portion of fund return that results in a performance fee. If a fund has both a hurdle rate and a perpetual high-water mark, incentive fees are paid only on the portion of the fund’s return above the return needed to reach the perpetual high-water mark plus the hurdle rate. EXAMPLE A hedge fund must earn a 10% return this year to reach its perpetual high-water mark. The fund also has a 5% hurdle rate. In this case, incentive fees will be paid only on the portion of the fund’s return above 15% (calculated as 10% + 5%). HEDGE FUND LIQUIDITY Investors in hedge funds must understand the potential illiquidity that is inherent in many of these products. Although the degree of liquidity differs with the nature of the alternative strategy being employed by the hedge fund manager, all hedge funds are less liquid than say mutual funds (or alternative mutual funds) because they are priced and traded less frequently. Unlike mutual funds which post a daily NAV, hedge funds typically are priced at the end of each month, meaning that no money can be added to or withdrawn from the fund except at the end of each calendar month. As well, in order to give the hedge fund manager time to liquidate positions to fund an investor’s withdrawal (without creating a significant market impact or trading cost) some funds have monthly subscriptions and quarterly redemptions with 30 days’ notice required before redemption. In addition to these types of liquidity dates, some hedge funds, because they invest in illiquid assets and can take large positions in a small number of issuers, have an initial lockup period (one to two years is common) during which initial investments cannot be redeemed. In a hard lockup period, investors are not allowed to redeem their interests during the lockup period for any reason. In a soft lockup period, investors can redeem their investments before the end of the lockup period by paying a fee. In addition to the above, some hedge funds may delay redemption requests even after investors have satisfied the lockup period. For example, many debt issues traded at extremely low prices during the 2008 financial crisis. Rather than allow hedge fund investors to redeem their investment, which would have forced hedge fund managers to sell these bonds at distressed prices, many credit-focused hedge funds delayed the redemption requests of their investors. © CANADIAN SECURITIES INSTITUTE  CHAPTER 20      ALTERNATIVE INVESTMENTS: BENEFITS, RISKS, AND STRUCTURE 20 15 Because of their complex strategies and limited liquidity, hedge funds have historically been considered too risky for retail investors, in contrast to conventional mutual funds, which maintain diverse, long-only portfolios of publicly traded securities and provide daily liquidity. Alternative mutual funds, which are discussed later in this chapter, are designed to offer retail investors some of the benefits of hedge funds while maintaining the liquidity and transparency of conventional mutual funds. FUND TRANSPARENCY Investors and their advisers rightfully expect a certain level of ongoing information regarding their investment products. This information is commonly referred to as product transparency. Product transparency involves three main factors: The level of detail provided The frequency of communication (i.e., daily, monthly, quarterly) The time between the fund reporting date and the date when the information is communicated to investors. For example, the nature and minimum level of fund transparency for conventional mutual funds and ETF investment products is stipulated in the distribution document (prospectus) for these two popular investment products respectively. For example, in terms of timeliness, ETF holdings are communicated with a one-day delay whereas conventional mutual funds are required to provide a detailed fund holding report on a quarterly basis. For hedge funds sold in the exempt marketplace, information regarding fund holdings and activity might only be reported semi-annually, and often with a 90-day delay. For exempt funds, information regarding the fund’s degree of transparency is provided in the hedge fund’s offering memorandum (which is not subject to regulatory restrictions). INVESTOR PROTECTION Rights of withdrawal permit a conventional mutual fund investor to cancel their investment without penalty within a two-business day period after they have received confirmation of their investment. This right also applies to investments in alternative mutual funds. Rights of withdrawal associated with the sale of hedge funds are stipulated in the fund’s offering memorandum and associated purchase agreements. ETF purchases do not have a right of withdrawal. Similarly, the right of rescission gives investors the right to rescind their purchase if the Fund Facts or simplified prospectus contains misrepresentations. This right applies to both conventual and alternative mutual funds but only applies to hedge funds if stipulated in the offering memorandum. ALTERNATIVE MUTUAL FUNDS (LIQUID ALTS) BACKGROUND Until recently, Canadian retail investors only had access to alternative investment strategies through a very limited selection of closed-end funds and commodity pools. Commodity pools were a type of fund in which managers were allowed greater, in comparison to conventional mutual funds, but still limited use of derivatives and leverage. Commodity pools were not allowed to short sell non-derivative related securities. This limited use has been unfortunate, particularly in market downturns, as some alternative investment strategies have been proven to provide good diversification away from traditional long-only investments in equities and bonds. This limited access to alternative strategies however has recently changed, with the Canadian Securities Administrators (CSA) modernization of Investment Product Regulation (NI 81-102). Included in the modernized regulation are provisions that will allow retail investors increased access to alternative strategies through a type of mutual fund known formally in the regulation as alternative mutual funds. Informally these funds are referred to as liquid alternatives or liquid alts. Regulators have essentially replaced commodity pools with alternative mutual funds and also increased the allowable activities of this type of fund. © CANADIAN SECURITIES INSTITUTE 20 16 CANADIAN SECURITIES COURSE      VOLUME 2 DID YOU KNOW? Commodity Pools that were in existence prior to the regulatory change automatically became alternative mutual funds when the CSA modernization amendments came into force on January 3, 2019. In general, these new rules for alternative mutual funds provide for greater usage of derivatives, leverage, and short selling than conventional mutual funds as well as a greater single issuer concentration. The alternative mutual funds still have limitations to each of these and therefore cannot use these to the extent they could be used by hedge funds. As well, alternative mutual funds have the same restrictions on investing in illiquid investments as conventional mutual funds. In the United States, the Securities and Exchange Commission revised mutual fund regulations to include alternative investment strategies in 2004. Both the number of liquid alt funds and their respective assets under management grew very slowly from the time of regulatory change to 2008. However, immediately after the 2008 financial crisis, US retail investors’ investment in liquid alt funds grew dramatically as they began to appreciate the diversification and capital preservation benefits that are typically demonstrated by these funds. Historically, conventional mutual funds and alternative investment vehicles such as hedge funds differed in many aspects. Here are a few examples of the differences: Conventional mutual funds offered daily liquidity while hedge funds offered very limited liquidity. Conventional mutual funds offered good transparency while hedge funds offered very limited transparency. Conventional mutual funds attempted to earn the highest relative return versus its peers while hedge funds strived to earn absolute (positive) returns regardless of market conditions. Alternative mutual funds offer an investment product that, for the most part, is a combination of the best aspects of conventional mutual funds and alternative investments. Alternative mutual funds provide retail investors with the following benefits: Access to investment strategies that were previously largely available only to exempt investors The goal of earning absolute returns during all phases of a market cycle The transparency, daily liquidity, and investor protection rights that are associated with conventional mutual funds (despite the ability of alternative funds to engage in riskier and potentially higher return strategies) Considerably lower minimum investment required in comparison to hedge funds Low fees, generally, in comparison to hedge funds DID YOU KNOW? Alternative mutual funds tend to have lower fees than those charged on hedge funds despite similar performance fee structures with respect to high-water marks and hurdle rates. According to the Alternative Investment Management Association, the average performance fee for alternative mutual funds is around 8%, compared with fees as high as 10%-to-20% for hedge funds. Both hedge funds and alternative mutual funds also charge management fees, generally in the 1%-to-2% range. There are trade-offs to investing in liquid alternatives. Not all alternative strategies (which are discussed in the next chapter) can be offered within a liquid alternative structure. Some strategies require the manager to have a lockup period that aligns the liquidity provided to the client with the time horizon of fund’s strategies. Liquid alternatives need to maintain some liquidity since they offer daily redemptions. As with conventional mutual funds, liquid alternatives can only invest up to 10% of the fund’s NAV in illiquid assets (based on NI 81-102). Illiquid assets are defined in the regulation as a “portfolio asset that cannot readily be disposed of through market facilities of which common quotations in public use are widely available at an amount that at least approximates the amount at which the portfolio asset is valued in calculating NAV per security of the investment fund”. © CANADIAN SECURITIES INSTITUTE  CHAPTER 20      ALTERNATIVE INVESTMENTS: BENEFITS, RISKS, AND STRUCTURE 20 17 Some examples of illiquid assets include penny stocks, ownership interests in private companies, collectibles like art and antiques, and some types of bonds and debt instruments. Based on these factors, a hedge fund’s potential return, in most cases, is higher than alternative mutual funds. FUNDS OF HEDGE (OR LIQUID ALTS) FUNDS Both hedge funds and liquid alts are able to invest up to 100% of their net assets in other mutual funds (including alternative mutual funds), thus creating a fund-of-funds structure. For the purpose of explanation, we refer below to this structure as a fund of hedge funds (FoHF), but it can just as easily be a fund of liquid alt funds. An FoHF is a portfolio of hedge funds overseen by a manager who determines which hedge funds to invest in and how much to invest in each. There are two main types of FoHF: Single-strategy, multi-manager funds invest in several funds that employ a similar strategy, such as long or short equity funds and convertible arbitrage funds. Multi-strategy, multi-manager funds invest in several funds that employ different strategies. ADVANTAGES OF FUNDS OF HEDGE FUNDS Funds of hedge funds have the following key advantages: Due diligence The task of selecting and monitoring alternative fund managers is time-consuming and requires specialized analytical skills and tools. Most individual and institutional investors do not have the time or expertise to conduct thorough due diligence and ongoing risk monitoring for hedge funds. An FoHF constitutes an effective way to outsource this function. Reduced volatility By investing in a number of different hedge funds, an FoHF should provide more consistent returns with lower volatility and risk than that of its underlying funds. Professional An experienced portfolio manager and his or her team evaluates the strategies employed management by the various fund managers and establishes the appropriate mix of strategies for the fund. Selecting funds that make up a low- or non-correlated portfolio requires detailed analysis and substantial due diligence. Ongoing monitoring is also required on each underlying fund to ensure that performance objectives continue to be met. Access to hedge funds Many hedge funds do not advertise, and many are not sold through traditional distribution channels. Information on some hedge funds is closely held and hard to access. Moreover, many successful hedge funds have reached their capacity limitations and either do not accept new money or accept money only from existing investors. Fund of hedge fund managers provide access to hedge funds for investors who would otherwise be shut out. Using their experience and contacts within the industry, reputable managers know how to reach hedge fund managers or how to obtain information on a particular fund and even reserve capacity with a fund. Ability to diversify with Funds of hedge funds increase access by smaller investors to hedge funds. Many a smaller investment Canadian hedge funds accept as little as $25,000 from accredited investors. However, some funds have a minimum investment threshold of US$1 million, with some as high as US$5 million or more. An investor would need to commit significant funds to achieve the equivalent diversification offered by an FoHF. © CANADIAN SECURITIES INSTITUTE 20 18 CANADIAN SECURITIES COURSE      VOLUME 2 Manager and business Hedge funds and, to a lesser extent, liquid alts have fewer regulatory restrictions than risk control more mainstream investments. Many investors therefore believe that some hedge fund management firms may terminate their activities for business or other reasons at any time. This risk is based on the fact that hedge fund management firms tend to be relatively small business concerns, the success of which often rests on one or a small number of managers and partners. Also, because some hedge funds pursue riskier investment strategies, they may be more likely to experience problems that could lead them to terminate the fund. This so-called blowup risk can be diversified away through an FoHF because any individual fund likely represents a relatively small fraction of the total assets invested. Additionally, the FoHF manager’s duty is to continuously monitor and manage underlying funds to mitigate business risk. DISADVANTAGES OF FUNDS OF HEDGE FUNDS Funds of hedge funds also have several disadvantages and risks, as follows: Additional costs Competent FoHF managers can be expensive to retain. Additional fees cover the management and operating expenses of the FoHF organization, as well as its margins. Most FoHFs charge a base fee and an incentive fee, in addition to the fees (both base and incentive) charged for the underlying hedge funds. A typical FoHF charges a 1% management fee and a 10% incentive fee, plus fund expenses. No guarantees of An FoHF does not constitute a guaranteed investment and cannot be assured of positive returns meeting its investment objectives. In fact, during certain periods, FoHF asset values will probably decline. You should make sure that your clients understand that the FoHF is simply the sum of its component hedge fund investments. Despite the claims of some hedge fund marketers, investors should not expect positive returns in every reporting period. Low or no strategy Some FoHFs are strategy-specific and invest only in one type of hedge fund, such as diversification long/short equity or convertible arbitrage. Such funds fill a specific role in the portfolio and may contribute less diversification than multi-strategy, multi-manager FoHFs. Insufficient or excessive The number of hedge funds in an FoHF can vary dramatically, from five to more than diversification 100 hedge funds. Some may not provide adequate diversification, depending on the objectives sought by the investor. Others may dilute returns and provide more diversification than the investor needs. Additional sources Some FoHFs add a second layer of leverage, above that used by the underlying hedge of leverage fund managers, to enhance the FoHF’s return potential. This strategy adds to the costs and risk of the FoHF. You should make sure that your clients understand this aspect of the strategy and agree to it. EXCHANGE-TRADED FUNDS Certain ETFs, like leveraged and inverse products, were regulated under NI 81-104 and as such have been already allowed a certain degree of flexibility with respect to derivatives and leverage (but not short selling of non- derivative securities). These strategies will be discussed in the alternative investment strategies lesson. They, along with all other ETFs that utilize alternative strategies will now be regulated under the modernized NI 81-102. © CANADIAN SECURITIES INSTITUTE  CHAPTER 20      ALTERNATIVE INVESTMENTS: BENEFITS, RISKS, AND STRUCTURE 20 19 In the United States, liquid alternative ETFs have grown in number and market share and now comprise slightly less than 10% of all liquid alternative investments. One of the main advantages of ETFs versus hedge funds or liquid alts is the ability to trade them intra-day on an exchange. It is questionable however whether this is an advantage when it comes to ETFs that utilize certain alternative strategies such as long/short. The value of being able to trade this type of liquid alt ETF may be very small. Nonetheless for other strategies intra-day trading may provide some advantage. COMPARING ALTERNATIVE MUTUAL FUNDS WITH CONVENTIONAL MUTUAL FUNDS AND HEDGE FUNDS 6 | Describe the similarities and differences between alternative mutual funds, hedge funds, and conventional mutual funds. As indicated earlier in the chapter, alternative strategies can be housed in a variety of investment structures, the most prominent of which are hedge funds and alternative mutual funds. Essentially, alternative mutual funds offer certain protections not found in hedge funds to investors who are looking for alternative strategies. For example, investors may have more protection in the areas of transparency, liquidity, and general regulatory oversight. There is a cost however to those protections. Although liquid alts can use leverage and short selling more liberally than mutual funds can, they do have more restrictions in these areas compared to hedge funds. For example, alternative mutual funds are able to short sell up to a maximum of 50% of the fund’s NAV, with no cash cover required. Mutual funds, in comparison, can short sell up to a maximum of only 20% of NAV, and they must have 150% cash cover. Hedge funds are able to short sell to any extent and without cash cover, depending on the details of their offering memorandum. With respect to the use of derivatives, liquid alternatives have just about as much flexibility as hedge funds. Like hedge funds, they are able to use derivatives in a non-hedging way (i.e., for speculation), without the need for cash cover. However, liquid alts are still subject to an overall leverage limit of 300% of NAV. Hedge funds may have a higher leverage limit, as long as it is consistent with the details of their offering memorandum. Conventional mutual funds can also use derivatives for speculation, but they require a 100% cash cover, and leverage is generally prohibited. KEY DIFFERENCES BETWEEN CONVENTIONAL MUTUAL FUNDS AND ALTERNATIVE FUNDS Table 20.2 provides a complete comparison of the main product features and regulatory restrictions for conventional mutual funds, traditional (exempt market) alternative funds (i.e., hedge funds), and alternative mutual funds respectively. The differences are broken down into the following categories: Regulatory disclosures Investment objectives Strategy allowances and limitations (including use of derivatives, short selling, leverage, physical commodities, and concentration of investments) Liquidity Fees Redemptions Permitted investors and size of initial investment Regulatory oversight © CANADIAN SECURITIES INSTITUTE 20 20 CANADIAN SECURITIES COURSE      VOLUME 2 Because of the differences between the two alternative strategy vehicles, hedge funds tend to demonstrate higher after-fee returns, but they do so by taking on higher risk. In other words, risk-adjusted returns between the two vehicles are similar. Hedge funds present investors with higher returns at higher levels of risk, whereas liquid alts tend to have slightly lower rates of return, but at lower levels of risk. Note, however, that during times of market distress, when there is generally a premium paid for liquidity, the differences in absolute returns narrows. Table 20.2 | Key Differences Between Conventional Mutual Funds, Hedge Funds and Alternative Mutual Funds Main Product Features Traditional (Exempt and Regulatory Conventional Market) Alternative Alternative Restrictions Mutual Funds Funds (Hedge Funds) Mutual Funds Regulatory Disclosures Offering documents Simplified prospectus Offering memorandum If listed on a stock exchange, then Annual Information Form (AIF) requirements are a long form prospectus Fund Facts document and ETF Facts If not listed on a stock exchange, then requires same disclosure as conventional mutual funds Fund NAV calculation Required to calculate Frequency set by offering Same as conventional frequency NAV weekly, unless they memorandum (usually mutual fund use specified derivatives monthly or quarterly) or short sell – in which case the NAV must be calculated daily Fund holdings disclosure Monthly: Top ten security Disclosure frequency Same as conventional (transparency) holdings stipulated in offering mutual fund memorandum (typically Quarterly: Complete fund semi-annual or annual) holdings report Continuous disclosure Mandatory disclosure: As per offering Same mandatory memorandum disclosures as Annual audited conventional mutual and semi-annual fund. Also, leverage unaudited financial disclosure statements Management reports of fund performance Annual information forms, and Timely disclosure of material changes © CANADIAN SECURITIES INSTITUTE  CHAPTER 20      ALTERNATIVE INVESTMENTS: BENEFITS, RISKS, AND STRUCTURE 20 21 Table 20.2 | Key Differences Between Conventional Mutual Funds, Hedge Funds and Alternative Mutual Funds Main Product Features Traditional (Exempt and Regulatory Conventional Market) Alternative Alternative Restrictions Mutual Funds Funds (Hedge Funds) Mutual Funds Investment Objective Investment objective Maximize relative return Maximize absolute return, Maximize absolute return, while providing downside while providing downside protection in falling protection in falling markets markets Strategy Allowances and Limitations Permitted borrowing Maximum 5% of fund Limit set by offering Maximum 50% of fund NAV at time of borrowing memorandum NAV for investment on a temporary basis, for purposes limited purposes Permitted short sale of a Maximum of 5% of fund Permitted as per offering Maximum of 10% of fund single issuer NAV memorandum NAV Permitted total short Maximum of 20% of fund Permitted as per offering Maximum of 50% of fund sales for fund NAV memorandum NAV Permitted total fund Maximum aggregate Limit set by offering Maximum aggregate leverage (combined borrowing and short memorandum borrowing and short limit on borrowing and selling of 25% of fund selling of 50% of short selling) NAV at any time fund NAV Aggregate gross exposure Maximum aggregate Limit set by offering Maximum aggregate borrowing and short memorandum gross exposure through selling of 25% of fund borrowing, short selling, NAV at any time and use of specified derivatives, of 300% of fund NAV Cash cover for short 150% cash cover required Limit set by offering Not required positions memorandum Diversification – Maximum of 10% of NAV Limit set by offering Maximum of 20% of NAV concentration invested in securities of memorandum invested in securities of (issuer level) any one issuer any one issuer Control Restriction Maximum 10% of the As per offering Same as conventional (a) votes attaching to memorandum mutual funds the outstanding voting securities of the issuer, or (b) the outstanding equity securities of the issuer, with limited carve-outs © CANADIAN SECURITIES INSTITUTE 20 22 CANADIAN SECURITIES COURSE      VOLUME 2 Table 20.2 | Key Differences Between Conventional Mutual Funds, Hedge Funds and Alternative Mutual Funds Main Product Features Traditional (Exempt and Regulatory Conventional Market) Alternative Alternative Restrictions Mutual Funds Funds (Hedge Funds) Mutual Funds Strategy Allowances and Limitations Limitation on exposure to Can invest up to As per offering Can invest up to 100% alternative mutual funds 100% of the fund’s memorandum of net assets in other net assets in any mutual funds (including other mutual alternative mutual funds) fund (other than thus creating a fund-of- an alternative funds structure mutual fund) Conventional mutual funds can invest up to 10% of fund’s net assets in alternative mutual funds Investment in physical Without an exemption, Limit set by offering Permitted commodities conventional mutual fund memorandum can invest up to 10% of the fund’s NAV directly in gold, silver, platinum and palladium or indirectly through specified derivatives Restriction to trade in Yes Restriction, if any, set by No restriction only ‘cleared specified offering memorandum derivatives’ (those cleared through a clearing agency regulated under the laws of either Canada, the United States, or Europe) OTC derivative single Maximum exposure of Limit set by offering Maximum exposure of counterparty exposure 10% of fund NAV to memorandum 10% of fund NAV to any one OTC derivative any one OTC derivative counterparty counterparty Restricted to deal only Required to deal only with Restriction, if any, set by Exempt from requirement with OTC derivative counterparties with an offering memorandum to deal only with OTC counterparties that ‘approved credit rating’ derivative counterparties have an ‘approved that have an ‘approved credit rating’ credit rating’ Derivatives for non- Cash cover required No cash cover No cash cover hedging purposes requirements requirements © CANADIAN SECURITIES INSTITUTE  CHAPTER 20      ALTERNATIVE INVESTMENTS: BENEFITS, RISKS, AND STRUCTURE 20 23 Table 20.2 | Key Differences Between Conventional Mutual Funds, Hedge Funds and Alternative Mutual Funds Main Product Features Traditional (Exempt and Regulatory Conventional Market) Alternative Alternative Restrictions Mutual Funds Funds (Hedge Funds) Mutual Funds Liquidity Investments in illiquid Maximum of 10% of fund Limit set by offering Same as conventional assets NAV at time of purchase. memorandum mutual funds Hard cap of 15% of fund NAV for up to 90 days Fees Charging management Yes As defined in offering Yes fees permitted memorandum Charging performance Yes, but can only charge Yes, but performance fees Yes, but performance fees fees permitted performance fees tied to normally charged based normally charged based a reference benchmark on the total return of the on the cumulative total or index fund itself return of the fund itself for the period that began immediately after the last period for which the performance fee was paid Commissions As permitted as per NI As per offering Same regulation 81-105 (Mutual Fund memorandum as conventional Sales Practices) mutual funds In particular, sales commissions cannot be charged to the fund but must be paid by the manager Redemptions Product redemption Usually daily Usually monthly, Usually daily sometimes quarterly Initial redemption Normally no redemption As defined in offering Redemptions can be deferral deferral time period memorandum (typically deferred for a time period (however, prospectus 30 days, but can have as long as six months normally allows for provision for longer time after the date on which redemption deferral periods under certain the receipt is issued for should manager deem circumstances) the initial prospectus appropriate in period(s) (provided it is disclosed in of market turmoil) the prospectus) © CANADIAN SECURITIES INSTITUTE 20 24 CANADIAN SECURITIES COURSE      VOLUME 2 Table 20.2 | Key Differences Between Conventional Mutual Funds, Hedge Funds and Alternative Mutual Funds Main Product Features Traditional (Exempt and Regulatory Conventional Market) Alternative Alternative Restrictions Mutual Funds Funds (Hedge Funds) Mutual Funds Permitted Investors and Size of Initial Investment Permitted investors General public Exempt, accredited, General public institutional, or minimum initial $150,000 investment Minimum initial Typically Typically Typically investment size $100 − $1,000 $100,000 − $150,000 $100 − $1,000 Minimum fund seed $150,000 provided by No minimum Same as conventional capital requirement for manager. mutual funds new funds Manager is able to redeem this seed capital once the fund has raised at least $500,000 Regulatory Oversight Investor rights of Right to cancel No right of withdrawal Same regulation as withdrawal investment within 48 except for as might conventional mutual fund hours of receipt of be detailed in offering confirmation purchase memorandum and associated purchase agreements Investor rights of Depending on the No right of rescission Same regulation as rescission province, investors unless otherwise conventional mutual fund maintain their right of stated in the offering damages or to rescind memorandum and the purchase if the associated purchase Fund Facts document, agreements simplified prospectus, AIF, or financial statements contain a misrepresentation Custodian Custodian must meet As per offering Same regulation as requirements as defined memorandum conventional mutual fund in regulations (NI 81-102) Ability for fund manager Prohibited As per offering Prohibited to receive reimbursement memorandum of organizational costs from the fund © CANADIAN SECURITIES INSTITUTE  CHAPTER 20      ALTERNATIVE INVESTMENTS: BENEFITS, RISKS, AND STRUCTURE 20 25 Table 20.2 | Key Differences Between Conventional Mutual Funds, Hedge Funds and Alternative Mutual Funds Main Product Features Traditional (Exempt and Regulatory Conventional Market) Alternative Alternative Restrictions Mutual Funds Funds (Hedge Funds) Mutual Funds Regulatory Oversight Security holder and All fundamental changes As per offering Same regulations as regulatory approval of require security holder memorandum conventional mutual fundamental changes approval. The primary funds ones are: Management and/ or performance fee increases Changes in the methodology of fee calculations Changes in the fund’s fundamental investment objective Change of manager and/or any reorganization Proficiency Requirement Investment Funds in Canadian Securities Canadian Securities for Mutual Fund Dealing Canada course, or Course, Derivatives Course, Derivatives Representatives Canadian Funds Course Fundamentals Course, Fundamentals Course, or Canadian Securities or Chartered Financial or Chartered Financial Course Analyst. These Analyst. These requirements are under requirements are under review by CIRO and CSA review by CIRO and CSA and are likely to change and are likely to change Proficiency Requirement Canadian Securities Basic licensing and a Basic licensing and a for CIRO Registered Course + Conduct and requirement to know your requirement to know your Representatives Practices Handbook + 90 product before selling to product before selling to Day Training + Wealth clients clients Management Essentials (within 30 months of licensing) © CANADIAN SECURITIES INSTITUTE 20 26 CANADIAN SECURITIES COURSE      VOLUME 2 HEDGE FUND ATTRIBUTES Which attributes of hedge funds contribute to decreasing and increasing portfolio risk? Complete the online learning activity to assess your knowledge. LIQUID ALTS COMPARED TO MUTUAL FUNDS Can you recall which conventional mutual fund and liquid alt features are different or the same? Complete the online learning activity to assess your knowledge. KEY TERMS & DEFINITIONS Can you read some definitions and identify the key terms from this chapter that match? Complete the online learning activity to assess your knowledge. © CANADIAN SECURITIES INSTITUTE  CHAPTER 20      ALTERNATIVE INVESTMENTS: BENEFITS, RISKS, AND STRUCTURE 20 27 SUMMARY In this chapter, you learned about the following key features of alternative investments: Alternative investments are asset classes that are different from the traditional three broad asset classes of equities, bonds, and cash. They are generally categorized into three groups: alternative strategy funds, alternative assets, and private equity. Alternative strategy funds fall into any of three general groups: relative value, event-driven, and directional. Alternative assets include commodities, real estate, collectibles, infrastructure investment, and natural resources. Three reasons to invest in alternative investments are to diversify, to add alpha, and to seek absolute returns. The efficient frontier represents the most efficient set of portfolios for all levels of risk. All points below the efficient frontier are inefficient because either risk can be reduced for a similar return or return potential can be increased for a similar level of risk. First-order risks relate to exposure to changes in the general direction of equity, fixed income, currency, and commodity markets. Second-order risks include liquidity, leverage, deal break, default, counterparty, trading, concentration, pricing model, and trading model risks. Operational risk relates to the alternative strategy fund as a business entity, and stems from potential system failures, as well as faulty settlement, reporting, and accounting procedures. Hedge funds are lightly regulated pools of capital whose managers are not constrained by the rules that apply to mutual funds. For example, they can take short positions, use derivatives for leverage, and perform arbitrage transactions. Investors in the retail market have access to hedge-fund-like products, such as alternative mutual funds and closed-end funds, that have fewer regulatory restrictions than mutual funds. Typically, hedge fund investors who are individuals must qualify under the accredited investor exemption. Hedge fund incentive fees can be subject to a high-water mark or a hurdle rate, or both. Alternative mutual funds, also referred to as liquid alternatives or liquid alts, have greater usage of derivatives, leverage, and short selling than conventional mutual funds, but face more restrictions than hedge funds. Advantages of funds of hedge funds include due diligence, reduced volatility, professional management, access to hedge funds, greater diversification with a smaller investment, and risk control. Disadvantages include additional costs, no guarantee of positive returns, low strategy diversification, insufficient or excessive diversification, and additional sources of leverage. REVIEW QUESTIONS Now that you have completed this chapter, you should be ready to answer the Chapter 20 Review Questions. FREQUENTLY ASKED QUESTIONS If you have any questions about this chapter, you may find answers in the online Chapter 20 FAQs. © CANADIAN SECURITIES INSTITUTE