Exchange traded fund investors who are wary of any further sudden market twists may consider liquid alternative investments that may zig as traditional assets zag.
On the recent webcast (available on demand for CE Credit), Smart Alternatives for Building Better Portfolios, Salvatore Bruno, Chief Investment Officer and Managing Director of IndexIQ, argued that investors are seeking diversification tools as the intertwined global financial markets have resulted in greater correlation across equity markets. For instance, in the period between 2000 through 2010, the MSCI EAFE Index exhibited a 0.88 correlation to the S&P 500 and the MSCI Emerging Markets Index showed a 0.79 correlation the U.S. benchmark.
On the other hand, looking at the past 18 years, a market neutral alternative strategy showed a 0.29 correlation to the S&P 500 and a -0.07 correlation to the Bloomberg Barclays U.S. Aggregate Bond Index. Additionally, the merger arbitrage exhibited a 0.57 correlation to the S&P 500 and a 0.00 correlation to the Agg.
As investors chase after rising stock returns, many will be exposed to sudden turns that may fuel portfolio volatility. Over the past decade, international stocks showed an annualized standard deviation of 18.3% and U.S. stocks had an annualized standard deviation of 15.0%. In contrast, hedge fund strategies experienced a 5.9% annualized standard deviation, allowing investors to have a smoother ride during more volatile conditions.
The Benefits of Absolute Return Strategies
These same absolute return strategies have also provided some decent returns. Bruno pointed out that absolute return strategies have historically delivered 3% to 6% over the risk free rate found in U.S. Treasuries. However, potential investors should keep in mind that these alternative strategies may underperform riskier assets like stocks during extended bull market runs.
As investors look into alternative strategies to hedge market risks, it is also important to not focus solely on a single liquid alt strategy. The HFRI Yield Alternatives Index was among the worst performing liquid alt strategies in 2017, but the same index was the best performer in 2016.
If investors are interested in alternatives exposure to hedge risks, it may be prudent to look at a multi-strategy approach, such as the IQ Hedge Multi-Strategy ETF (NYSEArca: QAI). QAI is the largest alternative strategy ETF on the market and 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.
Bruno explained that 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.
Investors would pay also traditionally pay “2 & 20” to gain access to these hedge fund strategies to gain access to unique strategies that enhance the risk/return profile of their portfolios. However, some of the favorite hedge fund strategies are now available within ETFs, like QAI.
Additionally, investors can also select single styles, such as Index IQ Merger Arbitrage ETF (NYSEArca: MNA). MNA would capitalize on arbitrage opportunities through mergers and acquisitions activities. MNA also takes a systematic, rules-based investment approach, IndexIQ analyzed almost 13,000 Merger & Acquisition transactions over 10 years and yielded the “ideal” characteristics of M&A transactions in regard to profits to shareholders, which were distilled into the rules-based process that drives the IQ Merger Arbitrage Index.
John Davi, Founder and CIO of Astoria Portfolio Advisors, explained that investors can incorporate alternative strategies as risk management tools to de-risk a diversified portfolio during times of distress. For example, a portfolio may look something like 40% to 60% equities, 15% to 20% bonds and 15% to 20% alternatives, with cash used opportunistically. Davi also pointed out that many large institutions, such as U.S. education endowments, allocate significant assets into alternatives – high net worth investors would typically hold 78% stocks/bonds with 22% allocated to alternatives.
Financial advisors who are interested in learning more about alternative investment strategies can watch the webcast here on demand.