12.2 Alternative Strategies, Performance Measurement & Due Diligence

Alternative investments are defined less by what they own than by the strategies they use. This section explains the main hedge fund strategy families, how alternative strategy performance is measured, and the due diligence and suitability work an advisor must do before recommending these products.

1. Core Alternative Investment Strategies

Hedge funds deploy diverse strategic playbooks designed to harvest idiosyncratic alpha or exploit specific structural anomalies. The five dominant classifications are detailed below:

1. Equity Long/Short

The most widely deployed hedge fund strategy. The manager conducts rigorous fundamental research to identify undervalued equities to purchase (long positions) while simultaneously shorting overvalued or structurally impaired companies.

• Gross Exposure: Sum of long positions plus absolute value of short positions divided by capital: $\text{Gross Exposure} = \frac{\text{Long Value} + |\text{Short Value}|}{\text{Fund NAV}}$
• Net Exposure: Difference between long positions and short positions divided by capital: $\text{Net Exposure} = \frac{\text{Long Value} - |\text{Short Value}|}{\text{Fund NAV}}$
• Example: A fund holding 90% long equity and 40% short equity possesses 130% gross exposure and a 50% net long exposure, reducing overall market sensitivity by half relative to a benchmark index.

2. Market Neutral

Market-neutral funds seek complete insulation from broader market direction. By matching long and short positions within the same industry sector, market capitalization tier, and beta profile, the manager targets a portfolio beta of zero ($\beta \approx 0$). Returns depend exclusively on stock-picking acumen (alpha), exhibiting near-zero correlation to the S&P/TSX Composite or S&P 500.

3. Event-Driven Strategies

Event-driven strategies exploit pricing discrepancies caused by major corporate catalysts:

• Merger Arbitrage (Risk Arbitrage): When Company A announces an agreement to acquire Company B for $50.00 cash per share, Company B's stock typically rises from its pre-announcement price of $40.00 to $48.00. The $2.00 gap reflects the risk that the deal may fail to close. The arbitrageur buys Company B at $48.00, capturing the $2.00 spread when the acquisition completes. In share-for-share mergers, the manager buys the target stock and shorts the acquiring company's stock according to the negotiated exchange ratio. The primary risk is deal failure (e.g., rejection by the Competition Bureau, regulatory intervention, or shareholder veto), which causes the target stock to collapse back toward its pre-announcement level.
• Distressed Securities: Investing in senior secured debt or subordinated bonds of corporations undergoing formal bankruptcy restructuring or reorganization under the Companies' Creditors Arrangement Act (CCAA) in Canada. Managers buy debt at deep discounts (e.g., 25 to 40 cents on the dollar), aiming to convert debt into controlling equity upon restructuring.

4. Relative Value Arbitrage

Exploiting temporary pricing discrepancies between closely related financial instruments that have a known mathematical relationship:

• Convertible Arbitrage: Purchasing an undervalued convertible bond while simultaneously shorting the underlying common stock to hedge equity risk. The manager monetizes the embedded option's cheap implied volatility and collects coupon income.
• Fixed-Income Arbitrage: Exploiting transient pricing dislocations along the Government of Canada yield curve, such as anomalies between on-the-run (newly issued) and off-the-run (seasoned) sovereign bonds.

5. Global Macro

Global macro managers adopt a top-down perspective, analyzing macroeconomic data, central bank interest rate policies, currency valuations, inflation trajectories, and geopolitical developments. They take large directional positions—often heavily leveraged via futures, forwards, and swaps—in sovereign bond markets, foreign exchange crosses, commodity futures, and national equity indexes.

Measuring Alternative Strategy Performance

Standard measures need care when applied to alternatives:

• Absolute-return targets. Many strategies aim for positive returns in all markets, so comparing them with a stock index can mislead. Managers often state a cash-plus or inflation-plus target.
• Risk-adjusted measures. The Sharpe ratio is common, but it can flatter strategies with infrequent, severe losses. The Sortino ratio (excess return ÷ downside deviation) and maximum drawdown show downside risk more directly.
• Index biases. Hedge fund indexes depend on voluntary reporting, so they suffer from survivorship bias (failed funds drop out) and backfill bias (funds add good past results when they start reporting).
• Smoothed prices. Illiquid holdings priced by models make returns look less volatile than they really are.

Due Diligence and Suitability

Before recommending an alternative strategy, an advisor should examine:

Under the Client Focused Reforms, the firm must understand the product (KYP) and the representative must judge it suitable and in the client's interest. Liquid alternatives are available to retail investors, but their leverage and complexity still require careful suitability analysis.