Understanding The Beta In ALFA

May 19, 2016

This article is part of a regular series on thought leadership from some of the more influential ETF strategists in the money management industry. Today's article is by Nathan Faber, vice president of investment strategies at Boston-based Newfound Research LLC.

Alternatives are often touted as being great diversifiers that have historically exhibited low correlations with equities as well as fixed income.

Source: Yahoo Finance, Newfound Research, S&P, CBOE. Russell 3000 is the iShares Russell 3000 ETF (IWV). 7-10 Year Treasuries is the iShares 7-10 Year Treasury Bond ETF (IEF). Value L/S is the ProShares RAFI Long/Short ETF (RALS). Long US Dollar is the WisdomTree Bloomberg US Dollar Bullish Fund (USDU) with the PowerShares DB US Dollar Bullish Fund (UUP) as a proxy prior to launch. Managed Futures is the WisdomTree Managed Futures Strategy Fund (WDTI). Merger Arbitrage is the MNA IQ Merger Arbitrage ETF (MNA). Floating Rate Notes is the iShares Floating Rate Bond ETF (FLOT). Put-Write is the Alps US Equity High Volatility Put Write ETF (HVPW) with the CBOE Put Write index used as a proxy prior to ETF inception. Hedge Fund Replication is the ProShares Hedge Replication ETF (HDG). Momentum Long/Short is the QuantShares Long/Short Momentum ETF (MOM). Size Long/Short is the QuantShares Long/Short SIZ ETF (SIZ). VIX Long/Short and VIX Tail Hedge are hypothetical and backtested dynamic allocations to XIV and VXX (with index proxies prior to launch) targeted to have neutral and net short exposure to VIX futures, respectively.

However, one problem many investors have with alternatives is that many of these alternatives can lag significantly during bull markets.

Note: 2011 is a partial year beginning 7/14/2011. 2016 is a partial year ending on 3/31/2016.

Source: Yahoo Finance, Newfound Research, S&P, CBOE. Russell 3000 is the iShares Russell 3000 ETF (IWV). 7-10 Year Treasuries is the iShares 7-10 Year Treasury Bond ETF (IEF). Value L/S is the ProShares RAFI Long/Short ETF (RALS). Long US Dollar is the WisdomTree Bloomberg US Dollar Bullish Fund (USDU) with the PowerShares DB US Dollar Bullish Fund (UUP) as a proxy prior to launch. Managed Futures is the WisdomTree Managed Futures Strategy Fund (WDTI). Merger Arbitrage is the MNA IQ Merger Arbitrage ETF (MNA). Floating Rate Notes is the iShares Floating Rate Bond ETF (FLOT). Put-Write is the Alps US Equity High Volatility Put Write ETF (HVPW) with the CBOE Put Write index used as a proxy prior to ETF inception. Hedge Fund Replication is the ProShares Hedge Replication ETF (HDG). Momentum Long/Short is the QuantShares Long/Short Momentum ETF (MOM). Size Long/Short is the QuantShares Long/Short SIZ ETF (SIZ). VIX Long/Short and VIX Tail Hedge are hypothetical and backtested dynamic allocations to XIV and VXX (with index proxies prior to launch) meant to have neutral and net short exposure to VIX futures, respectively.

While this lag is often an acknowledged cost of diversification, alternatives allocations in years like 2012, 2013 and 2014 can still seem like major performance drags.

Some ETF providers recognize this problem. For instance, the AlphaClone Alternative Alpha ETF (ALFA | C-32) seeks to be an alternative investment that combats some of these lagging returns during bull markets. On the alternative front, this ETF seeks to earn premiums by mimicking the holdings of a broad set of hedge funds.

A standard way of pursuing this premium as an alternative investment would then be to also mimic the short positions of the hedge funds so that the overall portfolio is equally long and short, either on a dollar or beta basis. By being long/short, the fund would hope to earn the performance difference between the two sleeves. This is a method we see used in other premium-seeking ETFs such as the QuantShares US Market Neutral Anti-Beta Fund (BTAL | F-38) and the ProShares RAFI Long/Short ETF (RALS | D-82).

But ALFA takes a different approach. It invests in the long leg of the trade, and only invests in the short leg when momentum in the S&P 500 is negative.

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