Retail investors have continued to pour money into stock and bond ETFs over the last two decades because they understand the value of a diversified, transparent, and low-cost investment vehicle that performs as advertised. However, one area of the ETF world that has yet to flourish has been alternative strategies.
An alternative ETF is one that implements a non-traditional asset class or investment approach that can include currencies, commodities, equities, bonds, futures, or cash. Most often a combination of these asset classes is implemented with strict rules on how the underlying index responds to changes in market conditions.
Many times alternative strategies will include tags such as “managed futures,” “absolute returns,” “market neutral,” “hedge,” and a variety of other industry terminology designed to describe their sophisticated features. However, this same nomenclature can be difficult for the vast majority of investors to decipher.
This is particularly true when fees and performance are included in the comparative analysis that leads to selecting an ETF to fit within a diversified portfolio. Alternative ETFs are notorious for having higher than average expense ratios to account for access to unique themes and unconventional markets. In addition, their performance won’t often correlate directly with stocks and bonds. This makes them a head scratcher for those who want to know how an investment will perform under certain conditions.
However, those same non-correlated returns are why institutional traders favor alternative investment strategies. They can often produce favorable performance under adverse conditions, which is the point of diversification. In addition, because of their multi-asset nature, they tend to have less overall volatility than an ETF that invests in one area of the market.
One of the largest ETFs in the alternative space is the IQ Hedge Multi-Strategy Tracker ETF (QAI), which currently controls nearly $800 million in total assets. As the name implies, the fund uses multiple asset classes and a long/short investing style to try and outperform the market. This passive index tries to replicate hedge fund-style returns by investing in a variety of underlying ETFs to compose its holdings.
QAI has total annual operating expenses of 0.94% and a beta to the S&P 500 ETF (SPY) of just 0.29. This means the fund is will be subject to much less overall volatility than a basket of large-cap equities. This low beta is a result of carrying both long and short positions in stocks and bonds according to the rules of the index.
Another well-known entrant in this space is the WisdomTree Managed Futures Strategy Fund (WDTI). This ETF seeks to achieve positive returns in both a rising and falling market using a quantitative strategy to switch between varying futures markets. This includes both long and short allocations to treasuries, currencies, commodities, and money market securities.
WDTI has $165 million in assets under management and charges a net expense ratio of 0.95%. The lack of equity exposure and direct access to futures market are just two differentiating factors that set WDTI apart.
Undeterred by the uncertainty of retail investors, PowerShares and First Trust recently launched new actively managed alternative ETFs designed to carve out a niche in this arena. The First Trust Morningstar Managed Futures Strategy Fund (FMF) invests in a broad array of futures products as determined by an investment team. The fund manager selects investments with varying maturities to try and beat a multi-asset benchmark developed by Morningstar.
The PowerShares Multi-Strategy Alternative Portfolio (LALT) is another active portfolio that seeks absolute returns in any market environment. This ETF includes exposure to VIX index futures, bonds, stocks, and currencies as a method of mitigating volatility. LALT currently has a net expense ratio of 0.96% as well.
Selecting which of these unique ETFs meet your investing style will require some additional research to determine the current composition and how the fund will adapt with respect to market changes. However, alternative ETFs can provide a measure of alpha during periods of uncertainty for traditional asset classes.