Alternative ETFs to Manage Market Risks, Diversify an Investment Portfolio

Investors who are worried that new surprises can continue to rock the markets may want to consider alternative exchange traded fund strategies that may zig while traditional assets zag.

Dan Petersen, Director of Product Management at IndexIQ, warned that investors should brace for more unknowns and these surprises may come more frequently.

Consequently, investors should incorporate alternatives to “provide returns that are mostly uncorrelated to traditional markets and bonds,” Petersen told ETF Trends.

We have all recently experienced the detriment of chasing after record high stocks markets. U.S. equities recently retreated in back-to-back losses after Federal Reserve Chairman Jerome Powell said on Wednesday trade tensions had returned to just a “simmer” and only adjusted interest rates without further forward guidance.

However, President Donald Trump threw a curve ball on Thursday, imposing additional tariffs that would cover the broad spectrum of Chinese imports and furthering throwing the markets into turmoil.

The sudden uncertainty may help put a spotlight on alternative investments that could hold up or help investors better manage risk in volatile conditions. For example, the Index IQ Merger Arbitrage ETF (NYSEArca: MNA) is an alternative investment strategy that could provide lower correlations to traditional stock and bond holdings. MNA is a way to provide investors with a diversified approach to a group of takeover targets. The ETF employ a type of alternative, “directional hedge fund strategy” called merger arbitrage. The fund would capture the spread or difference between a stock’s trading price before a deal is announced and its eventual takeover price.

Merger arbitrage is a hedged, alternative investment strategy designed to take advantage of price discrepancies that exit for companies involved in a merger. The strategy would purchase companies at prices below the target price and lock in the difference, or spread. By targeting this spread, the generated returns are generally outside of normal fluctuations of the broader market.

A merger arbitrage investment strategy may help investors garner more consistent returns and possibly deliver a smoother ride, serving as an important capital preservation tool and providing drawdown protection in times of volatile market conditions.

Along with its drawdown protection potential, a merger arbitrage strategy can also improve the risk-to-return profile of a traditional investment portfolio since the drivers of return for this type of strategy are isolated from broad market moves.

One may also look to something like the IQ Hedge Multi-Strategy ETF (NYSEArca: QAI), which provides a diversified mix of alternative strategies, including multiple hedge fund investment styles, such as long/short equity, global macro, market neutral, event-driven, fixed income arbitrage and emerging markets.

QAI first starts off by identifying ETFs that represent asset classes driving hedge fund returns. The ETF would replicate the risk/return profiles of 6 distinct hedge fund strategies. The hedge fund strategies are then combined into one portfolio to maximize returns and minimize volatility.

During periods of market selling in traditional assets, these types of liquid alternative strategies can experience lower drawdowns or even positive returns, which may help buoy an investment portfolio during troubled times. Nevertheless, potential investors should be aware that these types of investments are not meant as growth strategies to generate outsized returns in investment portfolios. In reality, these strategies are doing exactly what they were made for: diminishing volatility. Consequently, in bullish market conditions, the strategies may underperform, but if the markets turn, alts can shine.

For more information on alternative strategies, visit our alternatives category.