Investors who began using ALFA in the past year have experienced a very unattractive cost versus benefit. The recent underperformance of the hedge fund conviction exposures, as evidenced by the fully hedged version, has been exacerbated by the whipsaw cost in the beta control mechanism.
Source Yahoo Finance. Analysis by Newfound Research. Data through 4/30/2016. Data begins on ALFA’s inception date (5/31/2012).
We do not think this recent underperformance points to a systematic shortcoming in ALFA’s methodology, but we do think it highlights three points:
- It is important to understand your investments. ALFA does not just seek alpha in the traditional long/short factor premium harvesting sense. It also controls its beta exposure base on the market trends.
- Risk cannot be destroyed, only transformed. The addition of the beta control mitigates the risk of ALFA significantly underperforming in a strong bull market, but it introduces the risk of whipsaw.
- Multilayered risk management in a portfolio is crucial. ALFA’s net market exposure can range between 0% and 100%. When using ALFA, we prefer to assume a volatility profile that is more in line with the 100% state. This limits the allocation, and mitigates both the security selection and tactical whipsaw risk.
With the recent events in ALFA now under our belt, we have seen that sometimes the hedge fund conviction premium is reduced, sometimes the beta control leads to whipsaw, and sometimes these happen at the same time.
While ALFA may not be the purest way of harvesting the hedge fund conviction premium, it attempts to address the problem of lagging returns in alternatives during bull markets by controlling beta.
Digging deeper into an ETF’s process is never a bad thing for making an informed investment decision.
At the time of writing, Newfound Research held positions in ALFA in its Dynamic Alternatives and Total Return strategies. Newfound Research LLC is a Boston-based quantitative asset management firm focused on rules-based, outcome-oriented investment strategies. Newfound specializes in tactical asset allocation and risk management solutions. Founded in August 2008, Newfound offers a full suite of tactical ETF managed portfolios covering global equity, U.S. small-cap equity, multi-asset income, fixed-income and liquid alternative asset classes. For more information about Newfound Research LLC, call us at 617-531-9773, visit us at www.thinknewfound.com or email us at [email protected]. For a list of relevant disclosures, click here.