Digging Into The World Of Liquid Alt ETFs

February 17, 2015

Editor's Note: This story originally appeared in ETF Report.

The term "alternative investments" means different things to different people—some people consider anything that’s not a bond or a stock “alternative.” Here we’ll focus on what we think of as true alternatives; that is, strategies designed to provide positive returns that aren’t correlated with major asset classes.

These are the kinds of strategies often employed by successful hedge fund managers, and when successful, they provide positive, uncorrelated returns (also called “absolute returns”). The point isn’t shoot-the-lights-out performance; rather, robust diversification in a portfolio context.

The importance of alternatives as a diversifier is even more important in today’s low-interest-rate environment, with looming rate hikes making traditional diversifiers like bonds less attractive.

Historically, alternative investments have been available only to those at the top: institutional or high net worth individual investors. This exclusivity has to do with structure: Hedge funds are limited to selling to accredited investors, who have both high net worth and a willingness to put up with very low liquidity. Traditional hedge funds can lock up capital for years initially, and then allow only for withdrawals on a quarterly basis.

Liquid Alts For The Masses
In recent years, however, alternatives have become available to ordinary investors via ETFs. Traded on exchanges, alternatives in ETF form are much easier to buy and sell than traditional alternatives; hence the term “liquid alternatives.”

Liquid alternatives also do away with minimum investment requirements and typically offer greater transparency regarding holdings and the investment process. (Mutual funds—out of scope for this review—are also considered liquid alternatives, since they can be accessed daily.)

The Alt Landscape
Liquid-alternative ETFs are a very small—but growing—part of the ETF universe. Of the more than 1,650 ETFs in the U.S., we count only 35 of them as absolute-returns strategies, holding just $2 billion in assets—a tiny sliver of the $2 trillion in all U.S.-listed ETFs.

These assets are hugely unevenly distributed. The segment’s leader by AUM, the IQ Hedge Multi-Strategy Tracker ETF (QAI | B-73), constitutes roughly half of the entire class’ AUM, at just under $1 billion. At the other end of the AUM chart, most alternative ETFs have struggled to get any real traction among investors. Of the 35 alternative strategy funds, 28 of them have assets under $30 million.

Funds at the very bottom of the AUM barrel often trade poorly too, which leads to a situational irony: While ETFs have greatly improved access to alternative investments, many funds don’t trade well enough to be viable to the average investor. Those choosing among alternative ETFs should screen for size and liquidity first to narrow the field.

Still, investor interest in the space is picking up. Total AUM stands at about $2 billion, up from $1.5 billion a year ago, and new launches (and no closures) have increased the fund tally to 35 from 28.

No Vanilla Here: Sorting The Strategies
Almost by definition, alternatives ETFs can employ nearly any technique in the pursuit of absolute returns. Still, there are some common practices that let us bucket the main approaches.

Global macro funds use a top-down approach to invest across national borders and asset classes to take advantage of forecasts in changes in macroeconomic trends. These include changes in interest rates, currencies and broader factors like monetary policies and trade balances. An example is the IndexIQ IQ Hedge Macro Tracker ETF (MCRO | C-42).

Long/short strategies reduce exposure to long positions (generally in stocks) with partially or fully offsetting short positions. The positions are determined by fundamental or technical factors. A classic example is the ProShares RAFI Long/Short ETF (RALS | D-82), which chooses long and short U.S. equities based on factors such as cash flow, dividends, sales and book value.

Managed futures strategies use long and short positions in the futures markets for assets like commodities, financial indexes and currencies. Historically, managed futures strategies have done well when the underlying assets are trending strongly either up or down. The WisdomTree Managed Futures Strategy ETF (WDTI | C-73) is the most popular ETF of this type.

Multistrategy funds use a combination of strategies rather than relying on any single approach. QAI (mentioned above) fits this description.

Putting The ‘Liquid’ In Liquid Alts
If the strategies above sound familiar, that’s for good reason—they’ve been used by hedge funds and other illiquid vehicles for years. ETFs use a variety of means to make the strategies liquid and accessible.

The most straightforward way these strategies work is just direct implementation. A long/short fund like RALS, for example, is simply a fund that takes direct long and short positions in the underlying stocks, or enters into swap agreements trued-up on a daily basis.

But there’s a class of these funds that tries to mimic the performance of actual hedge funds through so-called hedge fund replication. The idea is to emulate a group of hedge funds that report their returns to third-party industry watchers, who roll all that reported performance into an index. A hedge-fund-replication ETF then uses fancy math to match the returns of the hedge fund index to a base of liquid underlying asset groups, such as emerging market equities or U.S. corporate bonds, which they then invest in.

Each of these approaches comes with trade-offs. Direct implementation is confined to liquid underlying assets, while hedge fund replication strategies may or may not catch the same underlying trends as the hedge funds they attempt to track in any period of time.

Getting Under The Hood
Regardless of the stated approach, an alternatives ETF is just an ETF. And like any ETF, how it’s structured is important both for risk and tax reasons, and is driven by the underlying assets it holds.

For example, the PowerShares DB G10 Currency Harvest ETF (DBV | C-42) directly implements its long/short currency strategy exclusively with forwards and futures, so it’s structured as a commodity pool, just like most ETFs that rely on directly owning futures. Here, investors receive a K-1 form at tax time, and any capital gains are taxed (at a blended rate) even if the investor didn’t sell the ETF shares.

Other funds, like WDTI, also access futures, but get around the ETF prohibition by technically just investing in an offshore subsidiary to get their exposure—a clever trick that lets them retain normal stocklike tax treatment.

ETNs like the iPath Optimized Currency Carry ETN (ICI | D-50) and the Credit Suisse Long/Short Liquid ETN (CSLS | C-67) differ in taxation depending on their underlying assets (currency ETNs are always just ordinary income, other ETNs are treated like a stock), and carry the counterparty risk of the issuing bank.

The bottom line: Legal structures add yet another step of due diligence for the liquid-alternatives investor (but are always available by typing in “etf.com/ICI” or any other ticker in your Web browser).

Alternative ETFs typically charge around 1%—some less; some much more. That’s much more than plain-Jane equity ETFs charge, but much less than the “2 and 20” traditionally charged by hedge funds (2% fee and 20% of gains). While comparing expense ratios can be confusing, theperformance of liquid ETFs is reflected by their net asset value, net of all fees and costs.

So How Do They Perform?
Given the diversity of assets, strategies, exposures and vehicles, evaluating the performance in the alternatives space isn’t easy. Popular references like the S&P 500 and 10-year Treasurys help to provide context for performance, but aren’t suitable as benchmarks. Investors can instead refer to the performance of hedge fund indexes, a simple blend of stocks and bonds, or even just the risk-free rate as a benchmark.

Beyond benchmarks, basic metrics like returns, volatility and correlation not only describe performance but also help manage expectations. For example, an investor who comes to liquid alternatives for diversification above all else might look for fully offsetting long/short exposure found in a market-neutral equity strategy or currency play like DBV. Conversely, an investor looking for higher returns who’s willing to bear some volatility and higher equity correlation might gravitate to a global macro strategy.

Still, looking beyond the strategy to the actual track record is the best way to understand how these strategies differ. We think the best tool is understanding the risk/reward trade-off in these funds and the correlation to equity markets. How they’ve performed, and with what volatility, is shown in Figure 1.

Their respective correlations to equity are shown in Figure 2.

A few things to notice from Figures 1 and 2:

· Alternative ETFs often produce negative returns, despite the “absolute returns” moniker

· Alternative ETFs generally lag equities when equity markets roar

· High correlation to equity boosts returns in bull equity markets, but reduces diversification

· Alternative ETFs that deliver low volatility aren’t likely to deliver high returns

These takeaways may seem obvious, but it’s important to keep the basics in mind when cutting through the thicket of marketing materials.

In summary, liquid-alternatives ETFs deliver access to markets that were once simply unavailable to most investors. They do so with great transparency and at lower cost compared with the traditional hedge fund vehicles.

However, the complexity of strategies, the structural implementation and performance evaluation make the due-diligence burden hefty—we’ve just scratched the surface.

Liquid-alternatives ETFs unquestionably widen the opportunity set for ordinary investors as they work to diversify their exposure, but perhaps in no corner of the ETF universe is digging deep into the funds you’re interested in more important.

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