Waiting For Their Big Break

April 23, 2012

  • Allocators: This smaller group of Alt-Es includes those funds that use a wide array of asset classes (equity, fixed, commodities, real estate, currencies) and a predetermined set of rules for tactically allocating a fund's assets. An example is the AdvisorShares Meidell Tactical Advantage ETF (NYSE Arca: MATH), the prospectus for which includes a description of its decision engine with this language: "MATH's quantitative process measures price velocity to determine which assets to invest in." Forgiving the editorial sin of ending the sentence in a preposition, the process of "price velocity" is open to discovery for potential investors.
  • Managed Futures Funds: Another small category of Alt-Es, these funds invest in any asset that trades in the financial futures markets and are generally managed using various forms of price momentum and trend- following techniques. The WisdomTree Managed Futures Strategy Fund (NYSE Arca: WDTI), for example, uses a broad array of commodities, currencies and financial futures. These funds typically have reasonably high levels of volatility and equitylike long-term returns, but with a very low correlation to equity markets.

Even with better classification, the hurdle remains high for alternative ETFs due to the lack of clarity in the security selection process. State Street Bank has no input into the decisions of Standard and Poor's as to which stocks go into the S&P 500—SSgA merely builds the portfolio from the publicly available index information. BlackRock doesn't time the purchase of gold based on a price-timing model. Rather, the iShares Gold Trust (NYSE Arca: IAU) simply tracks the price with its huge holdings. The lack of this simplicity—exemplified in the use of statistical models to generate return—makes an alternative ETF a very different investment.

To further growth in the Alt-E category, ETF sponsors must look deeply into the following issues, to overcome the natural disadvantage of the complexity of an alternative ETF:

  • Continue to innovate with new offerings.
  • Find creative portfolio uses for their new and existing strategies. As discussed, the buyers of Alt-Es will be by definition more sophisticated than the buyers of simpler ETFs; therefore, opportunities will exist to find ways to increase diversification, lower volatility and/or enhance returns with Alt-Es.
  • Educate, educate, educate. The higher level of complexity demands a higher level of buyer education before tickets will be written.
  • Keep implementation costs low so the higher fees can be used to pay for the additional education. Costs will only come down with much greater scale than exists today.

Buyers of alternative ETFs—portfolio managers, research analysts and consultants—must take a different approach to using Alt-Es than with traditional, well-known ETFs. Specifically:

  • The decision engine that underlies the basic risk/return characteristics of the ETF must be fully understood. Akin to buying an actively managed mutual fund, buying an Alt-E requires a level of diligence generally not conducted in ETF management. Ask the questions: "What is the theoretical basis for the decision algorithm to perform as presented? What are the practical implementation hurdles the fund must clear to perform as expected?"
  • Think creatively and openly about how a particular Alt-E might fit a specific portfolio application. For example, using an "anti-momentum" long/short ETF to hedge momentum factor exposure in an equity portfolio might make sense after a long period of price momentum outperformance.
  • Go slowly. Learn as you go. Regardless of the level of research and diligence before the initial purchase, nothing forces an investor to understand an investment like owning it for the first time. Some funds will not deliver on their promises, either through implementation slippage or poor model construction. In these cases, being on the bleeding edge is no fun.

Total combined assets in Alt-Es (using the IndexUniverse list of 27 funds) remain mired at a modest $1.4 billion. "Traditional" ETFs have seen runaway asset flows and accompanying massive commercial success, with just the top five largest funds combining for over $300 billion in AUM. To break this ceiling and to drive significant asset growth, Alt-E sponsors must focus on education and user development. Practitioners need to think critically about how to use Alt-Es in portfolios, either as complements to other portfolio pieces (most likely) or as stand-alone holdings. The future may be bright, but it's likely a slow, long road to arrive there.

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