Manager Insight

Liquid alternatives can provide protection and income, says Aston Hill's Ben Cheng.
By Michael Ryval | 03/12/15

The use of liquid alternatives in mutual funds -- providing diversification beyond the public markets -- involves derivatives-based strategies as well as private equity and private debt. It's an area of investing that has grown exponentially in the last five years in the global marketplace, and especially so in the U.S. According to the New York-based consulting firm Strategic Insight, these alternatives account for about US$350 billion in U.S. retail assets.

About the Author
Michael Ryval, a regular contributor to Morningstar, is a Toronto-based freelance writer who specializes in business and investing.

"That's from zero, basically," says Ben Cheng, chief investment officer at Toronto-based Aston Hill Asset Management. "But in the U.S., they have a much more relaxed set of rules and guidelines. In Canada, we still have to maintain the restrictions that come with mutual funds."

Aston Hill has been active in using liquid alternatives in some of its funds since late 2010. In early 2014, the firm, under Cheng's guidance, made a concerted push into using liquid alternatives across all its mutual funds.

While the extent of capital allocated to these strategies varies from fund to fund, the firm's so-called core equity, income and balanced funds actively employ liquid alternatives. That includes the newest member of the fund family, Aston Hill High Income, which was launched on Nov. 2 and is overseen by Cheng.

Driving the demand for liquid alternatives in the U.S., says Cheng, are investors who want to lower some of the correlations of their investments to the ups and downs of the broad financial markets. "They're looking for their fund managers to focus more on absolute returns, as opposed to relative returns," says Cheng, a 25-year veteran of the mutual-fund industry who joined Aston Hill in 2007.

"So, if the market is down 20% and your fund is down 18%, that's not a win," he says. "However, if your fund is down only 2%, that's considered a win. You can live with -2%, but it's hard to live with -20%."

In Canada, Cheng notes, fund managers that employ liquid alternatives are limited to a maximum of 20% short-selling, and unlike their U.S. counterparts cannot use leverage. Also, puts must be covered by cash. (That is, "naked" puts are not permitted.)

Cheng says that liquid alternatives have a two-fold purpose: downside protection of investor's capital, and additional income. In the first instance, Cheng and his team take advantage of periods of low volatility by buying protection when it is cheap and the market is rallying. "We can have a very large percentage of our investments protected in that environment."

When, for instance, the market falls 8% and volatility escalates, the team starts removing some of its protection and makes a profit in the process. "As volatility falls, we add insurance. As volatility spikes, we make money from the insurance and start laying it off. It's a dynamic process."

Secondly, the managers seek to add income by using puts. For instance, they will write puts 15% to 20% below the share price of several major U.S. financial-services stocks. In return, they collect 50 to 60 basis points (bps) of income. "We're not long that position, but we're getting 50 to 60 bps of premium," says Cheng, adding that he tends to write puts more often than calls.

"We still think there is upside in the financials, so then we buy some calls or the financials exchange-traded fund outright. If the stocks rally, as the Fed raises rates, then we benefit because the ETF is rallying. And we've added 50 to 60 bps of income. Aston Hill typically puts on option trades for short periods of time."

An alternative purpose of liquid alternatives is to get exposure to a specific stock. Cheng does this by writing a put, which allows the team to collect 30 to 40 bps of income and buy the stock when it falls to a target price. "You get no exposure, unless the stock falls 5% and hits your target price." In effect, says Cheng, the process "creates discipline for our buying and selling process. It also adds income to the portfolio. Today, we are very active on the options side."

Although Aston Hill does not use shorting currently, Cheng expects to use the strategy for six to 10% of the new fund. Private equity is another item in the liquid alternatives tool-bag, though Cheng says there is only one privately owned industrial real-estate firm in the portfolio. This U.S. holding is paying an 8% yield.

Private debt is another liquid alternative tool, and Cheng is holding one such instrument, which also pays an 8% yield. When the bond matures in 42 months, and the firm meets all its targets, Aston Hill will get an additional 20% payment.

Aston Hill limits private equity and private debt to 10% of the high-income portfolio. Recently, it was less than 3%. "As long as we manage these companies and know that they will continue to pay the coupon or dividends, the valuations will be stable," Cheng says.

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