Taking stock of these funds and the real-world results they have produced so far.
A version of this article was published in the January 2017 issue of Morningstar ETFInvestor. Download a complimentary copy of ETFInvestor here.
On paper, liquid alternatives exchange-traded funds appear to be full of promise. They represent the pairing of asset classes or strategies that provide uncorrelated returns with an investment vehicle that is cheap, transparent, and liquid. Here, I'll explore the paper case for liquid alternatives ETFs and the real-world results these funds have produced.
A Magic Asset Class
Investors have long sought a magic asset class, one that might diversify their stock and bond risk while providing positive returns. Through the years, many different assets and strategies have been deemed to hold such charm (REITs, commodities, long-short equity, merger arbitrage, and so on). Most have subsequently seen their powers chased away by diversifying hordes, go missing for extended periods, or be debunked by academics and practitioners. Nonetheless, our belief in magic will persist indefinitely.
One of the more recent manifestations of the pursuit of a magic asset class is the proliferation of liquid alternatives strategies that we have witnessed in the years following the financial crisis. In the depths of the drawdown, correlations between stocks and bonds spiked. During the period from Lehman Brothers' bankruptcy filing in September 2008 to the market's nadir in March 2009, the correlation between Vanguard Total Stock Market ETF VTI and Vanguard Total Bond Market ETF BND approached 1. Many shell-shocked investors emerged from this experience questioning the value of diversification (which seems to die more often than Tom Cruise's character from "The Edge of Tomorrow") and once again hoping to conjure some asset-class magic. As always, the asset-management industry was quick to get on the case, and a bevy of new liquid alternatives funds was born.
Cheaper, More Transparent, More Liquid
This new breed of liquid alternatives funds has aimed to improve upon prior generations. Fees are one area in which this class of funds is inarguably better than options such as hedge funds or commodity trading advisors. The classic 2-and-20 model has become a tough sale for a majority of hedge fund managers who lack the record to warrant such a fee arrangement. (Some have argued hedge funds are simply a compensation scheme masquerading as an asset class.) Transparency is also an area where liquid alternatives mutual funds and ETFs have an edge over hedge funds. Investors' demand to know what they own has increased substantially in the postcrisis period as many seemingly "safe" funds—even money market funds—experienced catastrophic meltdowns in the midst of the market malaise. Last, daily liquidity is what puts the "liquid" in liquid alternatives. Many hedge fund investors tried to run for the exits at the bottom of the bear market only to find the doors nailed shut. The gates and lockups that had once lent these funds an air of exclusivity became—in some cases—a guarantee of permanent capital impairment.
Do We Have a Match?
In theory, the marriage of an asset class or strategy with magical diversification properties and an investment wrapper that is low-cost, tax-efficient, and trades on an intraday basis would make for a postcrisis Hollywood ending. The reality hasn't been quite so rosy.
Since March 2009, 23 exchange-traded products have been introduced in the bear market, long-short equity, managed futures, market neutral, and multialternative Morningstar Categories. Each represents an attempt at making the type of love connection I described above. Here I'll take a closer look at 14 of these ETPs for which we have at least three years of performance data to see how they stack up.
Making the Grade
Remember, the holy grail is an asset class or strategy that has low correlations with other major asset classes and positive returns. Falling short on either front will not suffice. Exhibit 1 shows summary data for each of the 14 ETPs under examination. The "Correlation to Stocks" column measures the ETP's correlation to iShares Core S&P 500 IVV during the trailing three- and five-year periods ended Dec. 31, 2016. The "Correlation to Bonds" column measures the ETP's correlation to iShares Core US Aggregate Bond AGG during those same timeframes. I've also included total return and maximum drawdown figures.