Navigating Complexity In Liquid Alt ETFs

Hedge fund replication and other alternatives ETFs are great diversifiers, but going under the hood can be daunting.

Liquid alternatives ETFs—which include strategies such as hedge fund replication, managed futures and merger arbitrage—often shine when markets tumble because they offer alternative, often uncorrelated, return streams. They are great risk diversifiers. But this ETF segment, as a whole, has struggled to find traction, and this month, they lost a player when J.P. Morgan pulled the plug on four liquid alt ETFs, effective in June. Gathering assets has been difficult.  

The IQ Hedge Multi-Strategy Tracker ETF (QAI), launched in 2019, is one of the biggest ETFs in this space, with $810 million in assets. We chatted with Sal Bruno, chief investment officer of IndexIQ, to talk about the challenges this segment faces, and how investors can better navigate the complexity of these strategies.

ETF.com: There’s a lot of complexity in liquid alt ETFs. What is it about these strategies that makes it difficult to reach mainstream investors? Is there a way to improve accessibility?

Sal Bruno: Liquid alts should be able to find an audience—from your average retail advisor all the way up to institutions. But the use cases are different. Institutions are likely to perform much more detailed due diligence on the strategy than retail. But for both retail and institutional, the key is to understand how you can use them in your portfolio.

Institutional investors know why to add liquid alts to a portfolio. For them, it's more a question of which vehicle to use, which manager to hire, which strategy to allocate to. A strategy such as QAI could be useful for institutions where managers already know they want to have an allocation, but they may not have the right manager, or the right strategy. They need something that's liquid and easy to get access to that may be for a short, intermediate period of time. 

We spend more time educating retail investors, but probably less so on how it works, and more on how you use it. We can get people comfortable with the benefits of alternatives. Once you've established the need and the use case, you don't have to understand every detail of how it works, but you look at the results. You don't always understand the details of how a car works in terms of the firing of pistons and the combustion engine. You know you need it, and you know how to use it.

As an industry for liquid alts, we need to establish the need and the use case, and that will lead to better adoption.

ETF.com: If results are more important than understanding the mechanics of the strategy, as you say, it’s been a tough go for alts ETFs in terms of performance, even in the recent downturn, right?

(Here’s a look at QAI’s returns relative to the SPDR S&P 500 ETF Trust (SPY) year to date):

Chart courtesy of StockCharts.com

Bruno: We've faced a head wind up until this year. Liquid alts really started getting volume in 2007/2008, but it's been a tough environment in which to sell liquid alts. It's almost been like selling ice cubes on the North Pole. People have had great access to equity markets that have done really well for 11-plus years, and it's been hard to convince them that they need to diversify into alternatives, because every standard performance analysis showed performance dropped. No one necessarily wants that.

In the current environment, there’s more interest in looking at what liquid alts could do to your portfolio. During the drawdown from late February into late March, you could see how alternatives can help cushion the downside and mitigate some of the risks in the portfolio.

ETF.com: These strategies are often designed to provide consistent and uncorrelated returns, which are especially attractive in times of market turmoil. For that reason, isn’t it surprising to see a company like J.P. Morgan give up on its alts ETFs now? What’s the challenge here—performance, traction?

Bruno: When I look at the industry as a whole, and I look across the competitive landscape, to see one competitor dropping out might be taken as a sort of indictment against liquid alts. I don't think that it is.

When you look at liquid alts, and you look at hedge fund replication, there are only a couple of pure plays in the space. Some have moved towards active in their approach, and over certain periods, that has served them well. In other periods of time, it hasn't.

One of the appeals with QAI is that it’s passive. We try to make it as pure a replication play as we can. And in doing so, we try to deliver a consistent return, not necessarily to outperform.

If you're a golfer, you can try to hit it 400 yards off the tee. There's a chance you might shank it or put it into the water. If we can hit it 200 yards straight down the middle, we can do something with that. We're not trying to kill it; we're just trying to go right down the middle of the fairway.

Generally, we’ve done that, which is the appeal of the passive approach relative to the active approach.

ETF.com: You mention pure-play vs. active ETFs. If you’re a retail investor new to the liquid alts space, how do you best navigate the complexities of the different strategies?

Bruno: It comes down to knowing what you own. Understand the key drivers of the strategy. You don't have to understand every detail in the process, but what are the key drivers of the allocation? What is it trying to do? At the end of the day, can you understand what the results of the exposures are and how they're going to impact the portfolio?

When we talk to investors about QAI, we go as deep as they want, but for many investors, we leave it at: “We're trying to replicate the risk/return characteristics of hedge funds. We want to give you a return stream that looks and feels like the return stream you’d get from investing directly in a limited partner hedge fund. Period.”

We can go into the details of how we do that. You end up with an asset allocation where you’re 70% bonds, 28% stocks or whatever, a little commodity, and you have a little short volatility. You should understand what those exposures are and how they're likely to play out in different environments.

ETF.com: We’ve never used the word “unprecedented” this much before to describe markets and the world we live in today. In this context of “firsts,” is it easier or harder to pitch hedge fund replication and to implement these alts ETFs?

Bruno: The key is to understand that liquid alts is not a single thing. There are a number of different strategies that make up a liquid alternative platform or product solution set. And they range from things that are negative correlation, black swan, tail hedge, that are designed for those kinds of unprecedented shocks. When we're in that March scenario, most strategies can and should live up to expectations.

When we look across the risk spectrum of liquid alts, you start getting different levels of risk in market neutral, maybe multistrategies. They'll go down a lot less typically than the market. They may go down some, but they're going to provide some of the downside benefits of diversification.

Finally, we then have liquid alts run all the way to things like private equity or venture capital, where those are meant to be higher return offerings.

It's important in these “unprecedented” environments to understand that: (a) liquid alts does not mean just one thing; it's a range of potential solutions, and doing due diligence is very important; and (b) not every liquid alt is appropriate for every stage of every cycle. They're not magic bullets. Nobody can go from, “I'm going to be short the market from February 17 until March 23, and then I'm going to turn on a dime and go long on the market and catch all the upside.”

You have to understand how you're managing through that volatility, and the role that different types of liquid alts can play. Some are great for certain situations, doing a great job on the downside or on the upside. Some are better for all-weather type of environments. QAI is more of an all-weather type of hedge vehicle.

Contact Cinthia Murphy at [email protected]