YOUR GUIDE TO INVESTING IN LIQUID ALTERNATIVES

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1 YOUR GUIDE TO INVESTING IN LIQUID ALTERNATIVES Alternative sources of investment returns Improve diversification More tools to manage investment risk

2 TABLE OF CONTENTS Introduction 3 Defining the Space 3 Historical Context: US and Canada 3 Regulatory Environment and Proposed Changes in Canada 4 Liquid Alternative Mutual Funds versus Hedge Funds 4 Investment Tools & Strategies 5 Short Positions in a Portfolio 5 Using Leverage in a Portfolio 5 Equity Alternative Diversifiers 5 Fixed Income Diversifiers 5 Core Diversifiers 6 Absolute Return Multi-Strategy Mutual Funds 7 How to Add Liquid Alternatives to a Portfolio 7 Glossary 8 Cash borrowing 8 Physical short sales 8 Derivatives 8 Absolute Return 8 Call Option 9 Put Option 9 Forward Contract 10 Futures Contract Commodity Futures 11 Index Futures 11 Notional Value 11 Equity Futures 11 Bond Futures 11 Total Return Swap 12 Interest Rate Swap 12 Credit Default Swap 12 Definitions 13 2 Your Guide to Investing in Liquid Alternatives

3 YOU HAVE ALTERNATIVES Investors now have more options for increasing sources of returns, improving portfolio diversification and managing risk. These options are available in liquid alternative investment funds. Liquid alternative funds can give investors access to stocks and bonds plus other asset classes, including currencies, commodities and infrastructure. Liquid alternatives can invest stocks, bonds and alternative assets using non-traditional strategies and tools. These strategies include with the use of futures, forwards, options and other derivative instruments. The alternative tools include leverage and short-selling. The combination of alternative investment strategies, a wider range of asset classes and different investment tools can give investors a more flexible approach to investing. This alternative approach can generate additional sources of returns, improve diversification and use more tools to manage risk. This flexibility allows liquid alternative investments to behave more independently from stocks and bonds. Also, liquid alternative mutual funds offer daily liquidity: Investors can buy and sell them as they do with other mutual funds. Liquid alternative mutual funds became more popular in the US after the 2008 international financial crisis. These funds are now available to retail investors in Canada. Defining the Space: US and Canada Until recently, liquid alternative investments in Canada were only available to institutional investors and accredited (high net worth) investors. Now, Canada s investment market is opening up to liquid alternative funds for retail investors. Regulatory changes will give retail investors more access to liquid alternative investments to help diversify portfolios and increase the potential to achieve higher risk-adjusted returns. 1 The market for liquid alternative investments is expected to accelerate in Canada, as it has in the United States. The US Market Investor demand for liquid alternative mutual funds in the US increased after the global market disruption of and the volatility that followed. Alternative investments offered institutional and retail investors in the United States the opportunity to diversify away from stock and bond investing and dampen volatility. So, they embraced alternatives. They invested in alternatives such as hedge funds and private market funds, which were illiquid. However, investors soon realized they faced a major risk by not being able to rebalance quickly. Investor attention began to shift towards liquid alternative investments in a big way. They now wanted products that were easy to buy and easy to sell. Thus, the rise in Liquid Alternative mutual funds. The growing acceptance of liquid alternative mutual funds among US Investors led to a rapid increase in the number of strategies. This prompted investors to look for packaged solutions that allow them to access multiple strategies within the same fund. 1 Liquid Alternative Investments presentation by Keith Black at the CIBC Alts conference, CSA Notice and Request for Comment, Canadian Liquid Alternatives 2.0 white paper, CIBC Your Guide to Investing in Liquid Alternatives 3

4 The Canadian Market Institutional investors and high net worth investors in Canada have long recognized the value of alternatives for their portfolios. Holdings of these products have increased in recent years in Canada. As shown below, since 2011, Canadian externally-managed alternative assets have more than doubled from $84 billion in 2011 to $178 billion in Canada: Externally-Managed Alternative Assets (in Billions) (Hedge funds, real estate, private equity and infrastructure) $200 $150 $100 $50 $0 $ Growth Rates Yr Yr $ $ $129 Externally Managed Alternative Assets in Canada, Strategic Insight as of December This data accounts for all alternative strategies which include hedge funds, real estate, private equity and infrastructure. Even when retail investors did not have direct access to liquid alternatives, millions of Canadians were exposed through pension plans that invest heavily in alternative investments. For example, the Canada Pension Plan (CPP) alone holds over 50% of its $316.7 billion of net investible assets in alternative investments as at December 31, The Ontario Municipal Employees Retirement System (OMERS) and the Ontario Teachers Pension Plan are also heavily invested in alternatives $149 Demand for liquid alternative mutual funds is expected to increase among retail investors who want solutions to try to manage volatility and uncertainty in the markets. Canada s Regulation of Liquid Alternatives The Canadian Securities Administrators (CSA) is modernizing how it regulates liquid alternative investment funds as they become more mainstream. Overall, the regulatory framework is becoming simpler and more investor friendly. Liquid alternative mutual funds, under the regulatory changes, will be subject to the same ongoing disclosure requirements as conventional mutual funds and other prospectus-qualified investment funds. Liquid alt funds must comply with high standards of transparency and independent oversight in terms of their investment strategy, holdings and reporting $ Liquid Alternative Mutual Funds versus Hedge Funds Liquid alternatives are often compared to hedge funds because they can use certain alternative investment strategies available to hedge funds but in a restricted capacity as specified by regulators. That is where the similarity ends because liquid alternative mutual funds are not hedge funds. Hedge funds are basically only available to institutional and wealthy accredited investors, with good reason. They tend to be riskier, illiquid and less constrained by regulation. Liquid alternative funds, on the other hand, have the normal characteristics of a mutual fund that offers daily pricing, ease of buying and selling and the same legal and regulatory oversight that makes them appropriate for a retail investor. Here is a comparison of the major differences: Description Liquid Alternative Mutual Funds OSC Regulated Yes No Hedge Funds Can be sold to retail investors Yes No Can to be sold to unlimited number of investors Yes No Liquidity Primary Offering document Yes, daily Simplified Prospectus Easy point of entry/low minimum investment Yes No Transparency Tax reporting Performance fees Yes, same transparency as a mutual fund Simple No (conventional mutual fund) No, only periodic Offering Memorandum/ Subscription Agreement No Time consuming Yes 4 Your Guide to Investing in Liquid Alternatives

5 Common Alternative Tools and Strategies Liquid alternative investment strategies are built to provide something different. They are much less correlated to equity markets and aim to provide attractive returns independent of the direction of stock and bond markets. Alternative Investment Tools Managers of alternative investment strategies can make use of two main tools not available in traditional mutual funds: short positions and leverage. Using these tools can create portfolios with risk/return characteristics that differ from typical investments in stocks and bonds. Using Short Positions in a Portfolio The ability to profit when a security falls in value is the essence of shorting, and it provides portfolio managers greater flexibility to deliver performance from an asset class in a variety of market environments. The concept of shorting is counter-intuitive to the common investing principle of buy low and sell high. The way that portfolio managers generate a return with shorting is to take that principle and reverse it, with the hope of being able to sell high, and buy back lower in the future. Physical short selling involves the actual sale of a security the portfolio manager does not own, in the anticipation that the price of the security will decline, and they will be able to buy it back more cheaply in the future. The portfolio manager must borrow the securities they intend to short from a broker-dealer, with an obligation to return the same number of securities in the future. Shorting has the potential to magnify both gains and losses. Using Leverage in a Portfolio Leverage gets its name from physics: levers are simple machines used to create a force advantage between the load and the effort required to move it. In a company, leverage (created by adding debt to the capital structure) is used to try to enhance returns to shareholders. Similarly, in portfolios, leverage is the use of borrowed money or derivative instruments to increase the potential return on invested capital. It is two-sided, however. Leverage typically magnifies both gains and losses. Therefore, a leverage gain for the year means that the portfolio manager earned more profit on the money borrowed than the interest paid for the use of that borrowed money. Alternatively, a leverage loss is the opposite experience. In combination this is leverage risk. Leverage can be introduced to a portfolio in three main ways: Cash borrowing Physical short sales Derivatives Using shorting and leverage allows portfolio managers to create more precise beta exposure and risk/return characteristics of a portfolio. Beta is a statistical measure of how volatile a stock is relative to the stock market at large. These tools also allow managers to create portfolios with expected returns that are uncorrelated to other traditional investments in stocks or bonds. Alternative Investment Strategies Equity Alternative Diversifiers Long-Short Equity Long-short equity is a strategy that tries to profit from the up and down movements in individual stock prices and the stock market. Every stock has some amount of market exposure (beta) and stock-specific risk (alpha). The advantage of a long-short equity strategy is its ability to invest in these two exposures separately and in varying amounts as desired. The stocks in this strategy which are meant to benefit on the upside are bought and called long positions. Stocks meant to benefit from downward movement are sold and called short positions. The fund may also invest in securities meant to give exposure to the entire market whether long or short to give the fund any desired total amount of alpha and beta exposure. A long-short equity strategy might be run net long where there are more long positions than short ones. The strategy may also be net short where there are more short positions than long. Finally, the strategy might be market neutral, in which the weight of the long positions is approximately equal to the weight in the short positions. Fixed Income Diversifiers Credit Alts Strategy The objective of a credit alts strategy is to deliver attractive risk-adjusted returns independent of the general direction of credit markets, plus provide some downside protection. To achieve this goal, portfolio managers can use leverage when taking long positions. Historically, higher yielding credit markets have offered attractive riskadjusted returns compared with many other asset classes, including equities. Alternative credit strategies use systematic rules-based signals to allocate to or away from credit-oriented asset classes in the fixedincome universe. Your Guide to Investing in Liquid Alternatives 5

6 Core Diversifiers Global Tactical Asset Allocation (GTAA) GTAA is an alpha-seeking strategy that allocates across different equity markets, bond markets, types of bonds, commodities, currencies and cash. Its objective is to profit from asset classes that are rising in value and avoid those that are falling. The returns of a GTAA strategy are driven by global macroeconomic factors, such as supply and demand, the pace of general economic activity and interest rates. Contributions of idiosyncratic, company- or sector-specific returns may not be included. A GTAA strategy aims to deliver a specific risk-adjusted return for a liquid alternatives fund. The portfolio manager controls capital allocations to the individual markets and assets in such a way that the total fund delivers the desired return at the desired amount of risk. Currency Alpha Strategy This currency trading strategy attempts to profit from movements in relative exchange rates. Because each currency pair necessarily involves betting that one currency will outperform another, the strategy can gain from movements in exchange rates in either direction. The primary focus of the strategy is, therefore, to engage in relative value trades, focusing on how one currency will do relative to another. The strategy implies going long with one currency while simultaneously shorting another. Because currency forward contracts are used, the strategy also employs leverage (though not cash borrowing). Commodity Alpha Strategy A commodity trading strategy attempts to profit from movements in commodity prices, particularly in dislocations in commodity markets. This strategy will have the ability to gain from price movements in either direction, so being able to take a short position is critical. In addition, the strategy will engage in relative value trades, where the focus is on the dislocation in a commodity s price in relation to another. A relative value strategy will go long one commodity while simultaneously shorting another related commodity to profit from movement in the relative spread between two specific prices. The overall strategy is primarily neutral in terms of net long and net short positions, so that the cash value of the long positions is equal to the cash value of the short positions. The strategy will tend to incorporate several themes, including: Relative value: The difference in price between two commodities. Macro/industry conditions: Fundamental drivers of commodity price changes. Sentiment: Non-fundamental, shorter-term drivers of changes in commodity prices. Volatility Risk Premium Harvesting This strategy is based on being a seller of insurance against large and infrequent market declines. It can be expressed by selling, or being short, instruments that provide protection against prices declines, such as put contracts, or by creating short positions in volatility benchmarks like the Volatility Index (VIX). It can also be expressed by being long instruments that profit when volatility is low or falling. Risk Parity A risk parity strategy provides a framework for determining the optimal allocation to a variety of different asset classes. The objective is to collect each asset class s beta in a highly risk-managed manner, by allocating to each asset class proportionally to its risk. Low-risk asset classes will be levered up so that their risk, and hence their expected long-run return, is equalized to that of higher-risk assets classes. The principle of risk parity is that since we don t know the future, we should create a portfolio with equal allocations to asset classes that can perform in a variety of market conditions, so that the whole risk-parity portfolio will, therefore, perform in different market conditions. Typically, portfolios are built in capital space. For example, 60% of a portfolio s capital is allocated to equities and the remaining 40% to bonds. In contrast, risk parity strategies are built in risk space, that is, balancing the risk that comes from the equity allocation with the risk that comes from the bond allocation. Since bonds are less volatile than equities, to implement a risk parity strategy the portfolio manager must use leverage in the fixed-income portion. In essence, this involves borrowing money to buy significantly more bonds than equities. By adding leverage, the fixed-income allocation becomes as risky as the equity portion. Operationally, risk parity strategies can also be applied to different asset classes, such as commodities or various parts of the credit market. 6 Your Guide to Investing in Liquid Alternatives

7 Absolute Return Multi-Strategy Mutual Funds Absolute return mutual funds can use multiple alternative strategies to achieve specific objectives, such as delivering a target annual return over a market cycle, regardless of market conditions. They also seek to deliver low absolute risk (i.e., low volatility compared to a traditional balanced portfolio) and maintain low correlations to global stock and fixed-income markets. The portfolio manager combines strategies to invest the fund s assets, and uses tools like leverage and shorting to try to produce a specific return stream. Strategies are managed so that no single return stream dominates the overall fund. The manager analyzes the historical and forecasted risk and return of each strategy, as well as their correlations to each other and to equity and bond markets. That information is used to determine stable long-term weightings for the multiple strategies. Depending on market conditions, the portfolio manager can adjust each weighting within a modest range. The manager will determine whether, in the current market, each strategy is expected to deliver lower, equal or higher performance than the long-term historical data. For example, if a strategy has tended to outperform during a falling equity market, then its weight may be increased during an equity bear market. Or, if a strategy s historical data was generated in a period of low volatility, the strategy s weight may be adjusted downward in a period of high volatility. Meanwhile, the absolute return fund will be bound by risk controls that target a specific sensitivity to both global equity and fixed-income markets. To manage the portfolio s exposures and risk levels, the manager will maintain a full look-through into the holdings of each strategy at all times. This oversight allows them to stay on top of changing market conditions, including changes in correlations. The manager will also be able to monitor the degree of long/short exposure and the amount of leverage employed in real time. Being able to monitor the portfolio positioning will help ensure that manager actions don t result in the Fund breaching any of risk constraints. How to add Liquid Alternatives to a Portfolio There are three common approaches to using liquid alternatives in an investor portfolio: opportunistic, dedicated and integrated. The Opportunistic approach involves adding alternative investments to target a specific market opportunity or expected market conditions. Often, the use of alternatives is separate from decisions about the portfolio s equity or bond holdings. The Dedicated approach can use alternatives as a portfolio diversifier. Part of the portfolio is dedicated to alternatives, which, ideally, will contribute to the portfolio s diversification and stability. Daily liquidity allows for rebalancing and changes in asset allocation. Multi-strategy alternative funds can align with a dedicated approach because they give access to multiple strategies and can offer a range of alternative allocations. Dedicated Allocation Approach Equities Core Diversifying Alternatives Fixed Income The Integrated approach is often used as part of an overall strategy to use alternatives. The objective is to use alternative strategies and assets to complement other parts of the portfolio. The alternatives are used to improve diversification, enhance returns and manage risk. Liquid alternative mutual funds offer flexibility for rebalancing and risk management. Multi-strategy liquid alternative mutual funds may be an effective solution for investors who want an integrated approach because they can align with existing asset allocation and complement asset exposures. Integrated Allocation Approach Equities Fixed Income Equities Alternatives Core Diversifying Alternatives Fixed Income Alternatives Your Guide to Investing in Liquid Alternatives 7

8 GLOSSARY Cash borrowing A mutual fund can borrow cash, invest that cash, and benefit from any positive returns generated by those investments after the borrowed money plus interest has been repaid. This is similar to an individual investor using a margin account. Physical short sales As we discussed earlier, physical short sales involve borrowing a security and selling it at current market value, hoping to buy it back in the future at a lower price. The amount of margin generally required against a short sale is less than the full market value of the short position, thereby creating a leveraged position in the portfolio. Derivatives Many derivative instruments are particularly effective for creating leverage in a portfolio because they require low or, in some cases, zero upfront capital to gain exposure to an underlying asset. The notional amount of a derivative contract is the total value of the underlying security on which the derivative contract is based and can differ significantly from the market value of the derivative at any point in time. The notional amount can provide some indication of the degree of leverage the derivative contract is introducing to the portfolio. However, notional values are not particularly effective at indicating the potential risk or volatility of the derivatives position. The strike price of an option and the volatility of the underlying security are key determinants of a derivative s risk which are not captured by looking simply at notional value. In an alternative investment strategy, derivatives can be used for hedging purposes to reduce portfolio risk, or to implement a certain investment view. For example, put options can be purchased to hedge downside risk associated with a portfolio position, but could also be used to implement a view on the direction and volatility of the underlying security. Interest rate swaps can be used to hedge the duration of a portfolio s holdings but could also be used to implement a view on the direction and volatility of interest rates. Absolute return Absolute return is the return of an asset (stock, bond, fund etc.) over a certain period. This measure looks at the growth (or decline of the asset) over the period. Absolute return is typically displayed as a percentage of the assets original value, at the beginning of the given period of time. Example: If you put $100,000 dollars into a mutual fund and one year later the value has grown to $110,000, your absolute return is $10,000 or 10%. Additionally, if you put $100,000 dollars into a mutual fund and one year later the value has declined to $95,000 your absolute return is a loss of $5000 or -5.0%. $100,000 $110,000 Absolute return is often used in relation to relative return, which is the return an asset achieves over a period of time compared to a benchmark (a standard against which the performance of a fund, security or investment manager can be measured). $100,000 1 Year 1 Year Mutual Fund Benchmark $110,000 $10,000 $10,000 $5,000 Absolute return of $10,000 Relative return of $5,000 8 Your Guide to Investing in Liquid Alternatives

9 Call option A call option is an option contract in which the holder (buyer) has the right, but not the obligation, to buy a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration). The call buyer benefits when the stock price increases to a price well above their option s strike price. If the stock price does increase above the call s strike price, the call option s price increases, as the ability to buy shares at a much lower price becomes more valuable. Therefore, a trader who buys a call anticipates the stock price will increase. A call seller benefits when the stock s price trades below the option s strike price. If the stock does trade below the strike price, the call will expire worthless. As a result, the call seller will keep the premium collected for selling the call. Call options are typically used by investors for three primary purposes: 1. Tax management 2. Income generation 3. Speculation Expiration P/L Graph: Buying a Call Option +$2,000 Put option A put option is an option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time. This is the opposite of a call option, which gives the holder the right to buy shares. In other words, it is a bearish strategy that benefits from a drop in the stock price or an increase in implied volatility. Buying a put option is similar to shorting shares of stock, except buying puts has limited loss potential and a lower probability of profit since the break-even price will be lower than the current stock price. If the option expires out of the money, then your loss will only equal the premium you paid for the option. Expiration P/L Graph: Buying a Put Option Profit/Loss +$2,500 +$2,000 +$1,500 +$1,000 +$500 $0 Long Put Strike Breakeven Price Profit/Loss +$1,000 $0 Long Call Strike Breakeven Price -$500 -$1,000 $120 $130 $140 $150 $160 $170 $180 Stock Price Note: Holder = Buyer = Long put -$1,000 $75 $85 $95 $105 $115 $125 Stock Price Note: Holder = Buyer = Long call Your Guide to Investing in Liquid Alternatives 9

10 Forward contract A forward contract is a custom (unstandardized), non-exchange-traded agreement between two parties (a buyer and a seller). It obligates the buyer to purchase an asset (and obligates the seller to sell an asset) at an agreed price at a specified future date. For simplicity, let use sugar as an example. If you plan on producing one ton of sugar next year, you have two choices: 1) You could sell what you produced for whatever the prevailing price (spot price) is when you harvest in one year. or 2) You could sell a forward contract to a buyer (e.g., a bakery) for a fixed price today. In one year, the bakery will pay you the agreed fixed price in return for the one ton of sugar you promised in the contract, regardless of what the spot price is at that time. Note: Forward contracts bear a high risk because there is no clearinghouse involved that guarantees performance. Buyer Contract Agreement Today Seller One Year Settlement $$$ Asset Spot Price Agreed Price Future Date Futures contract A futures contract is a standardized contract agreement (i.e., each contract is set with the same size, price, currency and grade of asset, if applicable) between a buyer and a seller. The parties are obligated to exchange a certain asset for a predetermined price, on a specific day in the future (expiration date). It is important to note the key differences between a Forward contract and a Futures contract: Futures Margin Clearance Process Futures Contracts Forward Contracts Exchange Traded Yes No Regulated Yes No Standardized Yes No Counterpary Risk No Yes Upfront Costs Yes No Note: Unlike Forward contracts, Futures contracts are guaranteed by a clearinghouse and, therefore, mitigate the risk of default by either party in the intervening period. Client A Long 12 Contracts Client B Short 2 Contracts Broker 1 Long 10 Contracts Source: Exchange Clearing House Broker 2 Short 10 Contracts Client C Long 490 Contracts Client D Short 500 Contracts 10 Your Guide to Investing in Liquid Alternatives

11 Commodity futures A commodity futures contract is an agreement to buy or sell a predetermined amount of a commodity at a specific price on a specific date in the future. Buyers use such contracts to avoid the risks associated with the price fluctuations of the raw material in the spot market. Sellers use futures contracts to lock-in prices for their products to ensure stable income. Sample commodities with futures contracts traded on exchange: Precious metals: gold, silver, copper, platinum, lithium, etc. Energy: electricity, oil, natural gas, etc. Food: beef, pork, orange juice, rice, corns, grains, etc. Index futures An index future is another type of a futures contract that allows participants to buy or sell a standardized value of a stock index, on a future date at a specified price. This financial instrument combines features of securities trading based on stock indices with the features of commodity futures trading. Index futures allow participants to: 1 Leverage a long position if they believe the value of the stock index will increase 2 Short an index to protect from the downside price risk of the broader market 3 Hedge an existing long or short position Sample types of Index Futures: Dow Jones Industrial Average NASDAQ 100 Russell 2000 Index Standard & Poor s 500 Index Equity futures Stock futures are another type of futures contract between two parties to exchange a specified number of stocks of a publicly-traded company for a price agreed upon today with the physical exchange of securities and cash to occur at a specified future date. Equity futures allow participants to: 1 Leverage a long position if they believe the value of the stock will increase 2 Short a position if they believe the value of the stock will decrease 3. Hedge an existing long or short position Bond futures Bond futures are financial derivatives that obligate the contract holder to purchase or sell a bond on a specified date at a predetermined price. A bond future can be bought in a futures exchange market and the prices and dates are determined at the time the future is purchased. The bond contract is used for: 1 Hedging to protect an existing portfolio against adverse interest rate movements 2 Speculating in the hope of making a profit on short-term movements in prices. 3 Arbitrage purposes, i.e. profit from price differentials of similar products in different markets 4 Enhancing the long-term performance of a portfolio of assets. Notional value Notional value (also known as notional amount) is the total value of a derivative transaction, usually a swap, future or options contract. Notional value expresses how much total value the derivative theoretically controls. Notional value is the financial expression of the contract unit (number of units a typical contract controls) multiplied by the contract s price. The price of a gold contract is $10,000 This contract is a futures contract in the gold market Futures Contract Contract Unit (Multiplier) This contract obligates the buyer to 100 Troy Ounces of gold Price Notional Value Gold 100 Troy Ounces $1,000 $100,000 Crude Oil 1000 Barrels $50 $50,000 E-mini S&P 500 $ $106,000 The price of gold is trading at $1,000 (the spot price) Contract Unit The notional value of the contract is: 100 x 1,000 = 100,000 Price of gold Therefore, in this example, buying a $10,000 gold futures contract is similar to investing $100,000 (notional value of the contract) in the gold market. Your Guide to Investing in Liquid Alternatives 11

12 Total return swap A total return swap is a contract between two parties, in which party 1 (the payer and the owner of an asset) will pay party 2 (the receiver) the total return on an asset. In exchange for the payments from the asset, party 2 will pay an interest rate to party 1. This interest rate will typically be set based on a standardized rate (such as the rate banks set to borrow from each other) plus an additional spread (e.g., interbank rate of 1% + a spread of 2% = 3% interest rate). The payer is speculating that the asset will decline in value and, therefore, benefit from the fixed interest-rate payments. The receiver is speculating that the asset will increase in value and the total gain will be greater than the interest rate that the receiver is paying. Party 1 Party 2 Payer Speculating asset will decline in value Reference Asset Paying: Set rate + Spread Paying: Total Return + Change in value Receiver Speculating asset will increase in value The reference asset (typically a bond or stock) will have a market value and a coupon payment, in which both factors make up the total return of the asset. Interest rate swap An interest rate swap is an agreement between two counterparties in which one stream of future interest payments is exchanged for another based on a specified principal amount, over a set period of time. Swaps are derivative contracts and trade over-the-counter. While there are other types of interest rate swaps, the most commonly traded and most liquid interest rate swaps are known as plain vanilla swaps, which exchange fixed-rate payments for floating-rate payments based on the London Inter-Bank Offered Rate (LIBOR), which is the interest rate that high-credit quality banks charge one another for short-term financing. In other words, the receiver demands a fixed interest rate in exchange for the uncertainty of having to pay the short-term LIBOR (floating) rate over time. Credit default swap A credit default swap (CDS) is an over-the-counter derivative contract between two parties in which the buyer makes a series of cash payments to the seller and receives a promise of compensation for credit losses resulting from the default. Neither party needs to hold the underlying debt when entering into a swap. Credit Default Swap Seller Promises to pay swap buyer a set amount if WidgetCorp defaults, often $10 million Receives annual payments from swap buyer in return for insurance Can include banks, insurance companies, hedge funds or others WidgetCorp Borrows money from banks or issues bonds to finance operations Credit Default Swap Buyer Promises quarterly payments to swap seller Receives promise of large payout if bond defaults Can include banks, insurance companies, hedge funds or others If WidgetCorp s financial fortunes turn sour, the swap becomes more valuable. A swap holder can resell it and get high payments in return 12 Your Guide to Investing in Liquid Alternatives

13 DEFINITIONS Alpha Measures excess return relative to the market; often referred to as a measurement of manager skill. Barclays Capital U.S. Aggregated Bond Index An unmanaged index of investment-grade, U.S. dollar-denominated fixed income securities of domestic issuers having a maturity greater than one year. Barclay CTA Index A leading industry benchmark of representative performance of commodity trading advisors. There are currently 551 programs included in the calculation of the Barclay CTA Index for the year 2014, which is unweighted and rebalanced at the beginning of each year. Correlation A statistical measure of how two securities move in relation to each other. HFRI Fund of Funds Composite Index An equal weighted index of over 650 constituent hedge funds of funds that invest over a broad range of strategies. HFRI Equity Hedge Index These strategies maintain positions both long and short in primarily equity and equity derivative securities. A wide variety of investment processes can be employed to arrive at an investment decision, including both quantitative and fundamental techniques; strategies can be broadly diversified or narrowly focused on specific sectors and can range broadly in terms of levels of net exposure, leverage employed, holding period, concentrations of market capitalizations and valuation ranges of typical portfolios. Equity hedge managers would typically maintain at least 50% in equities, and may in some cases be entirely invested in equities, both long and short. HFRI Fund Weighted Composite Index This index is a global, equal-weighted index of over 2,000 singlemanager funds. Constituent funds report monthly net of all fees performance in U.S. dollars and have a minimum of $50 million under management or a 12-month track record of active performance. The index does not include funds of hedge funds. HFRI RV Fixed Income Corporate Index The index includes strategies in which the investment thesis is predicated on realization of a spread between related instruments in which one or multiple components of the spread is a corporate fixed income instruments. Fixed Income- Corporate strategies differ from Event Drive-Credit Arbitrage in that the former more typically involve more general market hedges which may vary in the degree to which they limit fixed income market exposure, while the latter typically involve arbitrage positions with little or no net credit market exposure, but are predicated on specific, anticipated, idiosyncratic developments. HFRI RV: Multi-Strategy Index This index employs an investment thesis predicated on realization of spread between related yield instruments in which one or multiple components of the spread contains a fixed income, derivative, equity, real estate, MLP or combination of these or other instruments. Strategies are typically quantitatively driven to measure the existing relationship between. Multi-strategy is not intended to provide broadest-based mass market investors appeal, but are most frequently distinguished from other arbitrage strategies in that they expect to maintain >30% of portfolio exposure in two or more strategies meaningfully distinct from each other. Your Guide to Investing in Liquid Alternatives 13

14 Short selling Physical short selling involves selling shares of a borrowed security in the open market with the expectation that the share price will decline. If the price drops, the portfolio manager buys the same number of shares at the lower price and returns them to the broker who loaned them. The portfolio manager has an obligation to return the same number of securities. The manager s profit is the difference between the proceeds from selling the stock at the higher price and the cost of buying it at the lower price, less any commissions. In short selling, the portfolio manager wants to sell low in the future. Generally, the portfolio manager must hold margin in an account with the broker who lends the securities, and there are costs associated with shorting. The borrower of the securities must make the lender whole for any dividends, distributions or interest payments paid on those assets during the period of the lending arrangement. Borrows Security XYZ Sells Security XYZ Prime Broker Investor Market Margin $50 Dividends, distributions or interest payments There are also derivative instruments that can be used to create a position that benefits when the price of the underlying security declines. Some examples include selling futures contracts, buying put options, or using various kinds of swaps. Using short positions enables managers to vary the extent that returns on the asset class influence the absolute return of the portfolio and, more precisely, target the portfolio s beta exposure. 14 Your Guide to Investing in Liquid Alternatives

15 NOTES Your Guide to Investing in Liquid Alternatives 15

16 Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. The content of this Guide (including facts, views, opinions, recommendations, descriptions of or references to, products or securities) are not to be used or construed as investment advice, as an offer to sell or the solicitation of an offer to buy, or an endorsement, recommendation or sponsorship of any entity or security cited. Although we endeavor to ensure its accuracy and completeness, we assume no responsibility for any reliance upon it Mackenzie Investments. All rights reserved AL7001 5/18