From CFA Montreal Association
A Q&A on hedge funds in Canada with:
- Marc Amirault, MBA, President and CEO, Director of Investments, Crystalline Management (single manager hedge fund business)
- Jean-François Papillon, MBA, CFA, Portfolio Manager and Wealth Advisor, BMO Nesbitt Burns
- Yves Caron, MBA, CFA, Vice-President, Research, iNFiNi-t Wealth Management Advisers Inc.
To begin, perhaps each of you could tell us a little about your experience in the hedge fund industry
present a diversification tool with little correlation to the other investment categories in my portfolio. I was seeking to reduce the overall volatility of my portfolio without compromising its performance. The interest levels and return profile versus the risks associated with bonds is another factor that helps promote the use of hedge funds. Certain hedge funds may use derivative instruments to provide the portfolio with a source of revenue without increasing its volatility.
How has the industry changed in the past 10 years?
M.A.: The level of refinement and overall knowledge about alternative strategies has increased among both institutional and private investors. This means that added value within a portfolio context is now better understood. In parallel the regulatory framework of the industry has also greatly expanded. This in itself is not a bad thing, despite the high costs involved, because it adds depth and legitimacy to the entire industry.
J-F.P.: I notice a slow progression or penetration of hedge funds among advisors, and I’d say that the category remains misunderstood by most of them. The more aggressive funds that use highly concentrated mandates in a few sectors with poorly managed risk are less common than before, while hedge funds offering low volatility and sound capital preservation have increased in popularity in recent years.
Y.C.: The industry has matured. It is more institutional and more specialized. The distribution of investors has shifted towards pension funds and other direct institutional allocators to the detriment of funds of funds, regulation has increased, and mandates have become more specialized. At the same time, hedge funds have evolved, and we are seeing increased transparency, more prominent risk management, and greater compliance.
Let’s turn now to our local markets. How would you describe the current Montreal hedge fund industry? (Feel free to respond according to your respective roles – allocation, management, distribution)
M.A.: The industry is doing well, after a difficult post-2008 crisis period. Newcomers to the market are establishing themselves, a new initiative has been introduced by Finance Montréal and EMB, and so on. The aim is to encourage the emergence and development of alternative managers on a more solid foundation. In our case we secured a number of mandates in 2015 and have launched a new global macro fund at the beginning of this year.
J-F.P.: Montreal is home to some well-respected management firms with a long history of returns. These firms remain little known by full-service advisors. However, I am noticing that hedge fund management firms are increasingly soliciting investment advisors who are established in the industry. This type of investment is no longer limited to family office or institutional managers.
Y.C.: The industry includes world-class managers, but it is struggling to raise enough assets to reach its full potential.
What do you believe is the biggest opportunity and the biggest challenge facing the industry in Montreal?
M.A.: The opportunity: to hire talented local candidates who hold graduate degrees and have extensive expertise in financial mathematics. The challenge: to win pension fund and Quebec institutional mandates.
J-F.P.: The opportunity is to increase the level of industry knowledge among advisors and brokerage firms. Many hedge fund mandates offer reduced risk and an excellent way to better preserve capital. Brokerage firms continue to view all hedge funds as high risk.
Y.C.: The industry faces the dilemma of the chicken and the egg. Without sufficient capital, it’s difficult to achieve critical mass. That being said, the Quebec Emerging Managers Programme’s alternative fund is an excellent initiative. The sustainability of the industry requires the launch of a second generation of funds by young professionals trained by the first generation. To begin with, existing funds need to grow and train more people. Then, these newly trained young people must take up the challenge of launching hedge funds either within traditional firms or as independent firms. The considerable challenge for a fledgling fund is that it must be launched with a clear competitive advantage and critical mass in order to draw capital from allocators focused on the alpha generated by young funds.
From a career point of view, what advice would you give a candidate or young professional whose goal is to join or start up a hedge fund?
M.A.: Focus on a specific aspect of alternative management (strategy, methods, pitfalls, etc.), and develop top-notch programming skills, notably in Python.
J-F.P.: Begin with a healthy amount of capital and a strong history of returns with an applied approach.
Y.C.: Before thinking about launching a hedge fund, consider working in an established hedge fund in order to learn about and become proficient using best practices. As with any entrepreneurial endeavour, an overnight success takes 20 years of hard work.
On a scale of 1 to 10, how would you rate the global investment environment when it comes to hedge fund strategies?
M.A.: I’d probably give the current environment a 6 to 7 rating, due to the overall underperformance of hedge funds relative to traditional asset indices that have been stoked by extremely accommodating monetary policies for the past seven years. I’d say a rating of 8 to 9 is realistic for the near future, because these unlimited liquidity conditions will soon be a thing of the past, but that implies that investors will have to do their homework.
J-F.P.: I’d give it 4 out of 10 in Canada, because we have a very limited choice of established firms.
Y.C.: I’d say 7 out of 10. There is good potential, given the mixed outlook of a traditional 60:40 portfolio over the coming years, but there are many challenges ahead as well.
In your opinion, what role do hedge funds play in a portfolio other than simple diversification?
M.A.: Alternative strategies can be viewed from two different angles: to reduce volatility (with uniform performance) or to generate added returns (with comparable volatility). In other words, based on the type of strategies deployed, hedge funds can indeed play a role other than simply one of diversification. In the case of pension funds, let’s not forget that regardless of an alternative strategy’s approach, the ultimate aim is to increase the likelihood of the fund meeting its actuarial requirements over time.
J-F.P.: They can also be used as a source of revenue. With interest rates being so low, bonds are no longer enough to meet the disbursement needs of retirees. It’s very important to have a sound risk management process to reduce the volatility of a portfolio in disbursement mode. More and more, interest rate variations will become a source of volatility for bonds. It is therefore vital to have tools in place to reduce this sensitivity to interest rate fluctuations without compromising the portfolio’s return. Hedge funds can isolate certain risks using derivatives, without touching the “revenue” component of the bonds.
Y.C.: Improving returns or risk by substituting hedge funds for either bonds or stocks. This improvement comes from the convexity and correlation of hedge funds.
We can’t discuss hedge funds without discussing their fees. We’ll keep the issue open and general and let you share your points of view on the subject as you see fit.
M.A.: The topic of fees has always spurred discussion…and yet, I believe that it should be considered in a strictly cost-benefit economic light. In other words, the quality of the results (risk/return) vs. the “offer” available (capacity) vs. the cost of obtaining the specialized service in question (irrespective of the fee). It’s important to understand that in principle, alternative strategies are developed and managed by exceptionally astute individuals. Are mid and long-term results part of the equation? That’s the real question. No one wins when an exorbitant price must be paid for “average” goods and services. Are you ready to pay more for a product or service that is worth more and that, by definition, will deliver a higher marginal benefit over time? The answer, at least my answer, is yes.
J-F.P.: Fees are generally higher for hedge funds. I find that in most cases, the hurdle rate used to calculate the performance fee is too low. I often see returns of +0% justifying the calculation of performance fees, but I believe that the hurdle rate should better reflect the risk investors expose themselves to (calculated based on volatility and growth potential).
Y.C.: The industry can no longer be based on the “heads I win, tails you lose” approach. All investors want to reduce risk while maintaining the same return or, conversely, want to generate a higher return while maintaining the same level of risk. And while reaching an improved risk/return profile justifies higher fees, it is difficult for most hedge funds to justify historic fees of 2% and 20%. A better alignment of interests begins with a minimum rate of return (treasury bills + x%) before the manager can receive any performance fees. Ideally, performance fees would be earned over a medium-term horizon (many years), which would prevent a situation where clients pay performance fees for one year, only to find themselves below the initial capital invested the following quarter or year.
Do you see accessibility to these products accelerating for individual investors? If so, how should the industry go about explaining the complexity of certain strategies without scaring off investors?
M.A.: The 2017 arrival of Liquid Alternatives to Canada’s regulatory landscape will change things considerably. I have no doubt that this rule change, which is still in the works and is expected to allow non-accredited individuals access to alternative investment strategies within a legal framework comparable to mutual funds, will definitely contribute to raising the profile of this investment universe and its lesser-known benefits among ordinary investors. By increasing people’s knowledge of the instrument and making more information available, many prejudices will disappear and, in the end, all investors will emerge winners.
J-F.P.: Yes, I see more and more firms offering alternative products to investment advisors. I don’t see firms soliciting the public directly. I believe that the first step is to increase knowledge among investment advisors and firms that offer this type of product to individual investors. There is still a significant lack of awareness on a compliance level and in departments responsible for assessing investment risk. It would be good to establish a system that would allow the various types of alternative mandates to be differentiated so as to simplify the selection process and better identify the variances in the risk levels from one mandate to the next.
Y.C.: Yes, by following the U.S. example. Hedge funds are a growth engine for fund managers. Simplicity should rule: what is the advantage of the product relative to stocks or bonds? How will the product increase the probability of achieving the portfolio’s objectives? And above all, how will it maximize the chances of achieving these objectives despite higher fees?
© CFA Montréal