Why Alts? 45 Hazelton Ave, Suite B, Toronto, ON, Canada M5R 2E3

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1 Why Alts? 45 Hazelton Ave, Suite B, Toronto, ON, Canada M5R 2E3

2 Why Do We Diversify? 2 The chart below shows two major asset classes over the last 20 years: stocks and bonds. Stocks are volatile but have higher returns, bonds are more stable but have lower returns. Importantly, they tend to be negatively correlated with each other. When one goes up the other goes down. 50/50 blend equity index uses S&P TSX Composite Total Return Index and S&P 500 Total Return Index in local currencies, rebalanced monthly. US Long Bond refers to Merrill Lynch 30-yr U.S. Treasury Futures Index. 2

3 Why Do We Diversify? 3 The magic of diversification! A blend of 60% stocks and 40% bonds (the 60/40 portfolio ) has higher returns and lower volatility than either asset by themselves. Bonds have done the bulk of the heavy lifting when it comes to portfolio protection. 50/50 blend equity index uses S&P TSX Composite Total Return Index and S&P 500 Total Return Index in local currencies, rebalanced monthly. US Long Bond refers to Merrill Lynch 30-yr U.S. Treasury Futures Index. 60/40 stocks/bonds assumes monthly rebalancing 3

4 What of the 40? 4 BUT, this has been an unprecedented period in the last 100 years! The next twenty years almost certainly don t look like the last twenty. Bond returns are a direct function of the yield you start with. Today, 10 year bonds yield ~2.7%. Your returns over the next 10 years will be (you guessed it) ~2.7%, or less than half of the returns of the previous 20 years. In 1949 yields were also 2.7% and rose to 7.7% over 20 years. The resulting comparative returns are shown below. US Corp AAA Bond Growth derived from Moody s Seasoned Aaa Corporate Bond Yield, source: FRED. Dow Jones Industrial refers to Dow Jones Industrial Average Price Return Index 4

5 The dangerous Buying and holding for the long run is great as long as the short run doesn t kill you. Managing drawdowns (the decline in value from a previous peak) matters if there isn t enough time to recover. A temporary loss of capital can become permanent if there is a spending need during a trough, or if an emotional decision triggers a sale at the lows. Equities offer the best long-term returns, but also come with unacceptable pullbacks for most investors. 5

6 An Alternative to What? 6 So, what are Alts an alternative to? Alternatives are best used as a bond-replacement, or as a hedge to equity downside volatility Alts raise the probability of a positive outcome, while decreasing the possibility of deep drawdowns Alts are risk-reducers, not risk enhancers *50% HFRI Equity Hedge Index / 50% HFRI Equity Market Neutral Index, rebalanced monthly 6

7 TRUE Liquid Alts Finally Coming to Canada 7 Properly run alternative funds should have a few consistent characteristics: Not highly correlated with typical asset classes Defensive in nature (i.e. actually have hedges!!) Have better risk-adjusted returns than traditional assets (i.e. trade off some upside for materially lower drawdowns) Alts use leverage and shorting (two things ironically viewed as inherently risky) to achieve this goal. Traditionally, these tools have only been available in OM funds to accredited investors. The CSA has proposed modifying the rules that govern mutual funds to allow for Alternative Strategies The rules will allow prospectus mutual funds to use up to 300% gross leverage in some cases, and have up to 50% of the portfolio in shorts without requiring cash cover Importantly, it is expected they will be properly risk-rated (i.e. low to medium), and be available to ALL investors whether they are accredited or not. Liquid Alts strategies that should fit the rules well include Equity Long/Short, Equity Market Neutral, Merger Arb Final rules expected this summer, but exemptive relief already being granted Expect new funds by end of summer 7