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.

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