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Summer 2019: Meaningful diversification with liquid alternative investments

Patrick Ercolano and Ian Taylor, Assistant Vice Presidents with the Investment Management and Strategy team here at MD, chat about non-traditional investments and the benefits of adding them to your portfolio.


Source: “MD compared the management expense ratio (MER) for MD mutual funds and MD Precision Portfolios™ with the average mutual fund MERs for comparable funds, using data from Investor Economics as of December 31, 2018.”



Patrick [00:00:04] Hello, I'm Patrick Ercolano and I'm here with Ian Taylor my co-Portfolio Manager for MD's Strategic Opportunities and Strategic Yield Funds. Today, we wanted to look at the benefits of adding non-traditional asset classes to an investor's portfolio, in particular liquid alternative investments. MD was ahead of the curve in launching its liquid alternative mutual funds more than five years ago, and increasingly we are seeing this becoming a mainstream investment option for individual investors in Canada. Ian, you're part of the launch of MD's liquid alternative investment back in early 2013. Maybe you can start by giving the listener an idea of what liquid alternatives are and why MD chose to create these solutions for clients?

Ian [00:00:45] Thanks Patrick. The definition of what qualifies as a liquid alternative investment can be quite broad. So I will speak to how we chose to approach this type of investing here at MD. Traditionally, the portfolio of a typical individual Canadian investor was made up of a few core asset classes. Mainly an allocation to Canadian equities typically focussed on stocks that trade on the TSX, an allocation to U.S. And international developed equities for stocks that traded in the U.S., Europe and developed Asia, and more recently in the past 10 to 15 years an allocation to larger companies located in emerging markets like Brazil, Russia, India and China. To add balance to the portfolio, investors here would primarily invest in high grade domestic government and corporate bonds. And that was pretty much it. About a decade ago with the increasing popularity of exchange traded funds, a trend emerged whereby the creators of ETF's started building products that would give investors access to asset classes that fell outside of the core asset classes I just mentioned. The goal with a launch of both the Strategic Opportunities and Strategic Yield Funds was to take advantage of this emerging trend by building two funds that would provide efficient cost effective exposure to a diversified portfolio of non-traditional asset classes to complement an investors' overall portfolio.

Patrick [00:02:03] You mentioned that we have two liquid alternative funds here at MD. The Strategic Opportunities and Strategic Yield Funds. What is the difference between these two products and what are the expected benefits of investing in each?


Ian [00:02:16] In the design phase for these funds, to give our financial advisors the most flexibility in constructing a portfolio, we decided to create two funds with different focuses. The Strategic Yield Fund is more income focus so not surprisingly its focus is on providing diversified access to higher yield non-traditional investments. These assets include investments in asset classes like preferred shares, convertible bonds, high yield debt, senior loans floating rate bonds and international and emerging market debt. Given the nature of these investments the risk associated with investing in this fund would be slightly more than a traditional bond fund but significantly less than an equity fund. To give an example of the enhanced yield, the Strategic Yield Fund, as of the end of June, was yielding 4.29%. This compares very favourably to a Government of Canada 10 year bond yield, just above 1.5%. The Strategic Opportunities Fund is more growth focussed and can invest across a wide range of asset classes including commodities, small and microcap equities, and sectors of the market that have shown to provide good diversification benefits like real estate and infrastructure securities. And there's also some interesting asset classes that are becoming more and more investable. Recently we've also added lithium and battery technologies to the portfolio. Both funds are truly global in nature providing additional benefits.

Patrick [00:03:38] As Co-Portfolio Manager, I know these funds are definitely not static in nature and this is a good opportunity to highlight the investment process driving their performance. What type of changes have the funds had since they launched?

Ian [00:03:53] Well as you mentioned Patrick, I guess one big change would be that we are now managing these funds internally, but also supported by a team of investment analysts. And that's great because these are truly customized products that would fit exclusively within an MD client's portfolio. Also as you mentioned the funds are definitely not static. We review the portfolios from a strategic perspective at least annually - but also make tactical decisions within the funds with a short term focus based on trends in the global business cycle. From a strategic perspective our process involves an in-depth review of the ETF landscape. As you can imagine with the popularity of ETF's, there are literally hundreds of options when it comes to investing. However not all ETF's are created equal. There can be major differences in the cost of ETF's, the transaction cost to trade them, liquidity, performance relative to the benchmark and whether the ETF actually holds an entire index or just tries to replicate it with fewer holdings. We look at the track record for the ETF, gain a deep understanding of what it is invested in and then meet with the ETF sponsor to get even more insight. We maintain relationships with all of the largest ETF providers and perform due diligence on each of these companies. It's an exhaustive process and a very important one given the rapidly evolving ETF market. Once we have identified the ETF's that are most attractive to invest and we apply quantitative techniques as part of a portfolio construction process to establish the right mix for each fund given their objective diversification is always a key focus but also the enhanced yield for the strategic Yield Fund and growth opportunity set for the Strategic Opportunities Fund. As I mentioned once we have established the right mix we will adjust it on a shorter term basis based on our market outlook.

Patrick [00:05:34] Are there any key trends the funds are taking advantage of now?

Ian [00:05:38] Absolutely Patrick. One is cost. The ETF landscape is very competitive and fees are coming down. This provides a direct benefit to each of the fund's performances. At MD we are very transparent about the all in cost of investments. Both funds are ranked in the top quartile as far as fees in their respective categories, which is consistent with the value MD has always sought to bring to our investors. In the Strategic Yield Fund, the global currency exposure has been a significant benefit to the fund since launch. However we felt it prudent to incorporate a hedge of some of the fund's currency exposure going forward to reduce the volatility of the fund and protect it against the potential for a stronger Canadian dollar. We have established that a 50% hedge ratio is optimal from a risk and return perspective for this fund. And then as an additional source of value add we have the flexibility to increase that or decrease that hedge by plus or minus 10% depending on our view of the Canadian dollar. So for example, right now we favour the Canadian dollar and as a result have a slightly higher level of hedge than we would in normal times. In the Strategic Opportunities Fund, one example of an exciting new asset class we are investing in is Emerging Markets small cap. If you look at the core large cap Emerging Market Index which investors are traditionally invested in, it has become more concentrated in China and Asia overall through the last decade. But the small cap space is incredibly well diversified with no individual sector or country making up more than 20% of the fund.

 [00:07:06] Okay. Thank you Ian. I think you have given a good overview of the benefits of investing in MD's liquid alternative investments, some of the key trends they are taking advantage of and how each funds may play a role in the investors portfolio. As always, if you would like more information about these funds please reach out to your MD Advisor.