3 Rules for Picking Alternative ETFs

Alternative investments, or simply alternatives, have become buzzwords in the industry, namely for their perceived benefits beyond traditional stocks and bonds. Alternatives range from highly liquid commodities to hedge funds and even nontraded vehicles that may not be investments at all. Not all investments can fit into the exchange-traded fund (ETF) wrapper; however, a subset of these alternatives dubbed "liquid alternatives" has seen a wave of issuance and growth in the ETF space. These typically include strategies such as managed futures, long/short, merger arbitrage and multistrategy funds, among others.

Many of these ETFs have come under scrutiny for their lack of effectiveness or liquidity. But if you stick to what I call the "three C's of liquid alts" – correlation, comprehension, and cost – then you and your clients will likely have a better experience with alternative ETFs.

Correlation

The entire goal of an alternative investment to traditional stocks and bonds is that it does not behave like traditional stocks and bonds. One of the best ways to measure that relationship is through correlation. Correlation measures how closely two securities move in relation to one another on a scale of negative 1 to 1. A correlation of zero shows no relationship between the two securities, with 1 being perfectly correlated and negative 1 being perfectly inverse. Generally, a correlation close to zero of an alternative ETF is preferred. Ideally, alternatives should perform when nothing else does, and correlation can help to identify those strategies. Typically, merger arbitrage, managed futures and some long/short strategies will have low and sometimes zero correlations. While correlation isn't as readily available as some statistical measures, it is worth the extra digging.

Comprehension

It seems like a no-brainer, but understanding what these liquid alternative strategies do is very important. "Popping the hood" is a great idea with any ETF, but multi-asset and strategy focused funds can change risk characteristics quickly, so a proper understanding of the strategy and how it reacts in different market environments is crucial. Many liquid alternative ETFs are fairly new, but their strategies or indexes will often have a lengthier track record that can be analyzed. As an example, alternative ETFs may react differently based on the speed and severity of a downturn, perhaps making it appropriate to blend ETFs to minimize those risks.

Cost

Finally, the costs — both implicit and explicit — of alternative ETFs are hugely important. Explicitly, it starts with the expense ratios and management fees of ETFs. In the universe of ETFs, those in the alternative space will generally be higher than average. However, access to these strategies has typically been available only to institutions or very wealthy investors and often comes at a price – both in high fees and restrictions to money movement. There are also costs of shorting securities that show up in the gross expense ratios of these ETFs. Shorting costs can be limited when using index-based futures but can get costly if the ETFs are actually selling short individual stocks. Implicitly, many alternative ETFs lack a high degree of "onscreen" liquidity and must be traded with caution. Watch for wide bid/ask spreads and be sure to contact your ETF liquidity provider when trading.

The inclusion of alternatives into a traditional balanced portfolio has been shown to provide risk and return benefits over time. Weighing the aforementioned "C"s of correlation, comprehension and cost when choosing between alternative ETFs is an involved exercise but worth the extra time. As the alternative ETF world evolves, proper due diligence on these products will undoubtedly expand; however, clients will benefit from continued inexpensive access to strategies previously reserved for accredited investors.

3 Rules for Picking Alternative ETFs

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3 Rules for Picking Alternative ETFs

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