By Grant Engelbart, CLS Investments
Currently, there is approximately $45 billion invested in alternative ETFs, according to Morningstar – just 2% of total ETF assets. Investors have been slow to adopt these products. In some cases, their hesitance is for good reason, but in others, it stems from a lack of understanding and implementation guidance. There are a number of reasons alternative ETFs have been avoided during their limited history; however, those reasons may face strong resistance going forward.
Since the 2008 financial crisis, there has been a consistent trend of positive bond and stock returns, with only a few years suffering major declines. Because of this, investors have had little reason to stray from traditional asset classes into the abyss of alternative products, let alone relatively new alternative ETFs. However, along the way there have been some glimmers of hope that may provide insight into the future.
The definition of what constitutes an alternative ETF varies widely. As defined by Morningstar, alternative ETFs can encompass nearly any product that contains derivatives – including leveraged ETFs, VIX products, currencies, and hedged equity. However, investors would be wise to focus on traditional alternative categories, such as long/short equity, managed futures, market neutral, and multi-alternative products. The goal of adding alternative products into a traditional, balanced portfolio is to take advantage of uncorrelated sources of return, enhancing risk management in portfolio construction. With proper diligence, one can find ETFs that exhibit these characteristics, despite criticism that implies otherwise.
Balanced portfolios of equities and fixed income have had significant tailwinds in recent years, and in situations where one component sputters (stocks fall or interest rates rise), the other has been there to offset it. However, with the Federal Reserve (Fed) having raised interest rates for the first time in a decade, the scenario of rising rates and falling stock prices may occur more often. This is where uncorrelated alternative strategies can be especially beneficial. Below is a sample of three ETFs in the long/short, market neutral, and managed futures categories. These categories have had low correlations to stocks and bonds and maintained standard deviations only slightly higher than fixed income. The chart indicates the percentage of weeks that these ETFs have had positive returns when the S&P 500 and U.S. Aggregate Bond indices have both been negative.
These examples have provided refuge in volatile times. Perhaps most importantly, in each week that stocks and bonds both fall, at a minimum one of the three ETFs listed has been positive, suggesting combining uncorrelated strategies makes a lot of sense. Those critical of alternatives, especially ETFs, should bear in mind the benefits of these products in such an environment, and users of alternative mutual funds should consider the benefits of cutting their costs in half (and then some).
The potential for growth in the alternative ETF space is tremendous. However, it will likely take established alternative asset managers to enter the ETF space in order to spark this growth. JP Morgan Asset Management launching a multi-alternative ETF this year is a great sign (it’s already one of the largest in the space). Others will have to grapple with cannibalization of their own higher-margin funds and strategies if they want to move into the space. However, as any true ETF believer will tell you, not launching an ETF is delaying the inevitable!
This information is prepared for general information only. Information contained herein is derived from sources we believe to be reliable, however, we do not represent that this information is complete or accurate and it should not be relied upon as such. All opinions expressed herein are subject to change without notice. The graphs and charts contained in this work are for informational purposes only. No graph or chart should be regarded as a guide to investing.
While some CLS portfolios may contain one or more of the specific funds mentioned, CLS is not making any comment as to the suitability of these, or any investment product for use in any portfolio. This information is for illustration purposes only and may not be representative of current or future portfolios. The information should not be considered investment advice. Past performance is not a guide to future results. 2785-CLS-12/21/2016