Therefore, the next step is to compare the characteristics of the ETF choices available versus their mutual fund brethren. While it is very easy just to look at the return differential, this may not exactly reflect what many investors consider the key benefit of holding alternatives, which is the diversification of risk from other holdings in a portfolio via a noncorrelated return stream. Positive returns may actually be less of a concern for investors than the correlation and volatility characteristics.
Morningstar recently came up with a method to more easily compare the different alternative options—whether it is a fund comparison within a category or a comparison of categories themselves. The tool is an alternative style box. (While I will not get into the specifics here, the report is available to read in its entirety.)
The alternative style box is essentially a scatter plot, with correlation to equity markets on the vertical and relative volatility on the horizontal. While the desired outcome is dependent on which category is being used, generally the effectiveness can be measured by low correlation and low volatility. Hence, the farther to the lower left of a style box and/or scatter, the better.
The following is a scatter of the alternative ETF universe. Similar to the Morningstar methodology, this only includes funds with a three-year track record (since three-year correlation and volatility are the inputs).
Not surprisingly, there have been more ETFs coming to market as demand for alternatives increases (whether as a function of innovation demand or worries about needing another asset class when faced with an extended equity market and historically low interest rates).
This analysis is slightly different in that I used the S&P 500 as the base for the calculations rather than a global equity index. While the themes should hold true despite the difference, there could be funds that have greater than 100% relative volatility versus the index, so my horizontal axis extends to 2 (200%).
Since I have a three-year track record requirement, the number of funds here will not match the table above. You can see that a few of the categories are somewhat sparsely represented.
Here is the same chart for the mutual fund universe: