Investors can look to exchange traded fund solutions to adapt to an environment characterized by volatile equity markets and low but rising interest rates.

In the recent webcast, Optimizing the 60/40 Portfolio Through Varying Market Conditions with Liquid Alts, Salvatore Bruno, Chief Investment Officer and Managing Director, IndexIQ; Kelly Ye, Director of Research, IndexIQ; and Dan Petersen, Director, Product Management, IndexIQ, outlined the current market situation and offered a look into liquid alternatives as a way to better manage market risks. Specifically, we are currently in a record-setting bull market that has lifted valuations to record high levels, which could expose investors to painful pullbacks. Meanwhile, interest may have finally bottomed out, with 10-year Treasury note yields touching a low of 0.53% back in 2020.

As a way to navigate this new pricey equity market and slowly rising rate environment. investors may consider liquid alternative ETFs that offer the highest degree of liquidity among alternatives and are a large and growing asset class. Choosing the right strategy depends on the current market environment and an investor’s investment objective.

IndexIQ classified Liquid Alts into three broad categories in a recent whitepaper based on their risk and return profiles, including diversifiers, volatility dampeners, and return enhancers. Liquid alts are diversifiers with attractive risk-adjusted return potential, exhibiting medium to low correlation to equities. They are volatility dampeners that show low or negative correlation to equities, with the potential to deliver “crisis alpha,” or positive return during large equity market sell-offs. Additionally, they can be return enhancers that exhibit attractive return potential, positively correlated to equities, as defined by the Chartered Alternative Investment Management Analyst Association.

In today’s market environment, liquid alts can serve as a ballast to a portfolio, providing returns where traditional assets have not.

For example, the higher rates environment is more favorable for Merger Arbitrage strategies. Merger Arbitrage has higher expected returns in higher risk-free rate environments as investors require greater compensation for the deal risk above and beyond the risk-free rate.

As a way to tap into the merger arbitrage strategy, investors can look to the IQ Merger Arbitrage ETF (NYSEArca: MNA), which employs a type of alternative, “directional hedge fund strategy” called merger arbitrage, where the fund tries to capture the spread between a stock’s trading price before a deal is announced and its eventual takeover price.

Improving Diversification

A merger arbitrage strategy may also help improve portfolio diversification. Merger arbitrage returns have not historically been materially influenced by the broader equity and fixed income markets, as demonstrated by its low correlation to broad market indices. MNA’s underlying IQ Merger Arbitrage Index showed a 0.06 correlation to the Bloomberg Barclays U.S. Aggregate Bond Index and a 0.44 correlation to the S&P 500 Index.

Furthermore, when added to a core bond allocation, liquid alts may mitigate duration risk. With increased expectations for CPI to rise and the potential for rising rates on the horizon, adding liquid alts to portfolios could diversify risk to fixed income exposures.

Their resilience also characterizes liquid alts during major market events. When the S&P 500 was down 1% or more, the IQ Hedge Multi-Strategy Index acts as the underlying benchmark for the IQ Hedge Multi-Strategy ETF (NYSEArca: QAI), experienced less drawdown 100% of the time since its inception. During large market drops of -1% to -3%, the IQ Merger Arbitrage Index had less drawdown 99% of the time. In market drops of more than -3%, it had less drawdown 100% of the time.

Multi-strategy liquid alts have historically demonstrated a low beta to equity markets and, therefore, can provide risk mitigation during periods of volatility. Looking at 3-month rolling returns, the IQ Hedge Multi-Strategy Index showed a 0.26 beta to the S&P 500.

Liquid Alt ETFs are seen as a potential substitute for getting alternative exposure, whether it is in a partially liquid hedge fund or a liquid private equity type of vehicle. According to a recent Greenwich survey, many survey respondents, particularly Family Offices, lean toward alternative ETFs for long-term and strategic purposes. Among respondents not currently using liquid alternative ETFs, almost 20% will consider using them next year.

Liquid Alt ETFs provide a similar risk-return profile without drawbacks. About half the institutional investors in the study use fund-of-funds for alternative exposures. Fund-of-funds account for about 20% of overall alternative allocations. Nearly 20% of study participants consider replacing a portion of their funds-of-funds allocation with liquid alt ETFs in the next 12 months.

Additionally, Liquid Alt ETFs allowed for continued market exposure while searching. Survey respondents revealed that approximately 3-7% of their firm’s alternatives portfolios are undergoing a transition at any given time. Currently, money market funds and cash are the most common vehicles used for portfolio transitions. On the other hand, 25% of respondents indicated that they are “likely” or “somewhat likely” to consider using alternative ETFs to manage transitions believing the vehicle provides efficient market exposure at a reasonable cost.

Four IndexIQ ETF strategies are combined to create the multi-alternative approach of QAI, which replicates six common hedge fund investment styles. The four funds include the IQ Hedge Long/Short Tracker ETF (NYSEArca: QLS), IQ Hedge Macro Tracker ETF (NYSEArca: MCRO), IQ Hedge Market Neutral Tracker ETF (NYSEArca: QMN), and IQ Hedge Event-Driven Tracker ETF (NYSEArca: QED).

Financial advisors who are interested in learning more about liquid alts can watch the webcast here on demand.