By Andrew Beer, Managing Partner at Dynamic Beta Investments

The market for alternative ETFs is in its infancy. Today, there are only a handful of active, alternative ETFs with assets greater than $100 million, and trading is sparse. More broadly, the liquid alternative market – which consists almost entirely of mutual funds – is going through a major re-assessment as an estimated 80-90% of products have underperformed expectations due to high fees and/or design issues.

To take a step back, investors in ETFs in general have a different mindset than investors in mutual funds.  Starting with an asset allocation model, the ETF investor seeks products that can efficiently deliver the performance of a given category of assets, but also with high predictability. The performance of the asset category drives performance, not the acumen of a manager hired to outperform it (e.g. a typical active mutual fund). An allocator who invests in an S&P 500 ETF never has to worry about underperforming the index.

What does this mean for retail and other investors who seek ETFs that provide the diversification benefits of hedge funds but with reasonable fees, daily liquidity and other attractive features (e.g. tax efficiency)?

At Dynamic Beta investments (DBi), we argue that alternative ETFs need to accomplish three objectives. First, they should match or outperform the category of hedge funds, even though actual hedge funds are illiquid and available only to high net worth or institutional investors. This is critical given that allocators use historical performance of actual hedge funds —data that goes back to the 1990s – when building capital market assumptions. Across the liquid alternative landscape, too many funds have systemically underperformed actual hedge funds by around 200 bps: in other words, up to 40% of returns were lost in the effort to make the strategies available to retail investors. For the allocator, this can terminally undermine the rationale for adding alternatives in the first place.

Second, performance must closely match the category over time. Just as traditional ETFs are invested in dozens or hundreds of underlying securities, alternative ETFs should provide exposure that is akin to a highly-diversified portfolio of hedge funds (like a hedge fund index). Whereas a typical index-hugging, large cap US stock manager might deviate from the S&P 500 by 50-100 bps a year, the top decile of hedge funds in a given category will outperform the worst by 25% or more a year.  In the hedge fund space, this is called “single manager risk.”  For the allocator concerned foremost about getting exposure to the asset class, this is as risky as replacing the S&P with a single stock.

Third, fees must be low enough to make the investment attractive in an increasingly fee sensitive world. Granted, while alternative ETFs are in a grey area between high cost, actively managed mutual funds and bargain basement core ETFs, it fair to expect all-in expenses to come in at or below 100 bps.

Some current ETF products accomplish these objectives, but most do not. For instance, there are four funds that seek to deliver performance akin to a hedge fund index – theoretically ideal for an allocator seeking a “one stop” solution. Index IQ (QAI) and ProShares (HDG) manage funds have delivered most, but not all, of the returns of a widely-followed hedge fund index; with the longest track record in the space and respectable performance, QAI is the largest alternative ETF with over $1 billion in assets.  (Note that a fifth ETF, from Goldman Sachs, that builds on the success of Goldman’s $2 billion mutual fund, has the potential to deliver similar results over time.)  By contrast, JP Morgan (JPHF) and Powershares (LALT) launched products that seek to deliver similar results, yet have underperformed by a wide margin. These funds have all the hallmarks and risks of single manager funds, a serious problem for allocators when material underperformance can raise questions about the integrity of the overall asset allocation. There are similar examples in the long/short equity, managed futures and other categories.

The geometric growth of ETF-based model portfolios means that there is enormous pent up demand for products that can deliver on the three objectives above. As wealth management firms compete against robo advisors and other low cost, but limited, portfolio solutions, they require alternative ETFs that provide diversification to ensure their clients meet their long-term investment objectives. Widespread adoption may then disrupt the liquid alternatives space in the same way that traditional ETFs have upended the mutual fund industry. For the end investor, this is something to look forward to.