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.

This selective hedging, while optimistic in its goal, opens the fund up to whipsaw risk, as can be seen in ALFA’s performance over the first few months of 2016.

Source Yahoo Finance. Analysis by Newfound Research. Data through 4/30/2016.

From the middle of February, ALFA, which had until that point tracked the SPDR S&P 500 ETF Trust (SPY | A-97), began to diverge significantly as SPY rebounded. ALFA had a hedged position for the entire first quarter. Without even looking at the fund holdings or its fact sheet, we can see this by looking at ALFA’s rolling beta, which has dropped recently.

Source Yahoo Finance. Analysis by Newfound Research. Data through 4/30/2016. Data begins on ALFA’s inception date (5/31/2012).

Unfortunately, its alpha has also dropped in tandem.

Source Yahoo Finance. Analysis by Newfound Research. Data through 4/30/2016. Data begins on ALFA’s inception date (5/31/2012).

 

ALFA doesn’t seem to be living up to its name.

But as with everything, there are costs and benefits.

To isolate the cost of whipsaw, we can construct a fully unhedged version of ALFA by adding back in the market return in months when it was hedged.

To isolate the benefit of selectively shorting the market, we can construct a fully hedged version of ALFA by subtracting the market return in months when it was unhedged.

The beta of these two approaches is shown below to put some context around the beta of ALFA. The alphas are essentially similar.

Source Yahoo Finance. Analysis by Newfound Research. Data through 4/30/2016. Data begins on ALFA’s inception date (5/31/2012).

 

ALFA was long only until September 2015, so any cost of whipsaw has only been realized in the past eight months. Over this period, ALFA was down 22.0% versus 16.4% in the unhedged index, a cost of 5.6% for the beta control.

On the other hand, the fully hedged index was down 21.3% over the period, which means the short positions outperformed the long positions.

This gives us some context for the whipsaw, and shows what we noticed in the alpha graph above: The premium in the hedge fund conviction just wasn’t as strong as it has been previously. But this is a common occurrence in all ETFs seeking factor premiums. If premiums always were strong, they somewhat paradoxically wouldn’t always be around. There must be some short-term variation for long-term outperformance to exist.

While the beta control was a drag on returns recently, extending our view back in history shows how strong the benefit of not always being long/short has been. The chart below shows the cumulative return of ALFA and our two hypothetical indexes.

Source Yahoo Finance. Analysis by Newfound Research. Data through 4/30/2016. Data begins on ALFA’s inception date (5/31/2012).

 

Up until ALFA first signaled a hedge at the end of August 2015, it had outperformed the fully hedged index by nearly 65%. Over the entire period, relative to the fully hedged version, ALFA was up nearly 50%, greatly eclipsing the cost of the recent whipsaw.

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:

  1. 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.
  2. 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.
  3. 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.

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