The ETF universe is rapidly expanding, not only in number of funds and total assets, but also in the proliferation of more sophisticated strategies, many of which were previously available only to institutional and other high net worth investors. These "alternative" strategies include hedge fund replication, long/short, managed-futures, real-return, volatility-linked and others. They offer ETF advantages such as liquidity and transparency, and have come to be known as "liquid alt ETFs."
Another advantage of liquid alt ETFs is that the costs are generally lower than the typical "2 and 20" fees charged by hedge funds. Additionally, the fees are included in the net asset value and therefore the performance, making comparisons with other ETFs and mutual funds easier.
Liquid alt ETFs and mutual funds have restrictions on leverage and liquidity that prevent them from entirely replicating hedge fund strategies; as a result, performance may be diluted relative to traditional hedge funds. However, their liquidity and transparency offer clear advantages.
Managing A Liquid Alt ETF
Many liquid alt ETFs—while based on relatively sophisticated strategies—employ a passive approach, meaning they are managed to track an index. Similar to other passive ETFs, the portfolio manager monitors the holdings to ensure that the characteristics of the fund are closely aligned with those of the index, either through a replication approach or representative sampling. Trading is done as needed for cash management, due to corporate actions, or to ensure the fund is properly aligned with the index.
Unlike more traditional passive ETFs, however, the implementation of liquid alt ETFs is anything but passive. For example, shorted securities and futures cannot be transferred in-kind; therefore, the portfolio manager is responsible for executing trades that would otherwise be completed by in-kind transfer, such as for a rebalance or to facilitate creation/redemption activity.
Trading A Long/Short Strategy
The WeatherStorm Forensic Accounting Long-Short ETF (Fund) is a 130/30 fund, with a target 100 percent net equity exposure via long and short positions in U.S. equity securities; Vident Investment Advisory, LLC (VIA), acts as subadvisor to the Fund. The Vident team manages the short positions via a prime brokerage account, monitoring margin requirements and collateral positions on the shorts while maintaining the total net equity position to track the characteristics and performance of the benchmark index.
When creations and redemptions occur, while the AP delivers or receives the long positions via in-kind, unlike in a long-only fund, the value of the shorted securities is transferred as cash, and the underlying positions are transacted by Vident.
During quarterly rebalances of the Fund, the short exposure is adjusted through a combination of covering and putting on new shorts, adjusting collateral positions, and ensuring margin requirements are met. This is an addition to implementing the transactions on the long positions as well, to align the total portfolio with the new index.
Liquid alt ETFs do not always have the same level of tax efficiency as traditional long-only ETFs. While the shorted securities provide investors with potential return enhancement if they underperform, the current tax-friendly treatment of in-kind transactions is not realized on the shorts, so there may be tax consequences. Additionally, how the ETF is structured can have an impact on an investor's tax liability. For example, ETFs structured as a partnership must pass-through income, expenses and capital gains to each shareholder on a pro rata basis; this is in addition to gains or losses realized when selling shares of the ETF.
Any investment in a liquid alt ETF should be carefully evaluated to ensure that the strategy, as well as the structure and implementation, meets an investor's needs. The implementation—that is, the management and trading of the underlying portfolio—can impact the performance of the fund. The effectiveness of trading and tax management can help reduce the expected tracking error versus the benchmark index, and can help reduce after-tax cost to investors.
Denise Krisko, CFA, is president of Vident Investment Advisory, LLC.