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Most Liquid Alternatives ETFs Have Failed to Make the Grade

Taking stock of these funds and the real-world results they have produced so far.

Ben Johnson, 02/01/2017

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.

Exhibit 2 is a report card of sorts (the type you wouldn't want to bring home to mom). Remember, to have the potential to add value in the context of a stock/bond portfolio, an allocation to an alterna­tive strategy must have low correlations to the other pieces of the portfolio and positive returns. In grading these funds, I used a correlation of 0.50 to IVV as my dividing line. ETPs with a three-year correla­tion to IVV less than 0.50 passed; those with a correlation greater than 0.50 got a failing grade. As for returns, I used bonds as my benchmark. ETPs that posted three-year total returns that exceeded AGG's passed, and those that fell short received an F.

Just one of the 14 ETPs examined here managed to pass this test based on its performance during the past three years: IQ Merger Arbitrage ETF MNA.

To be fair, three years is a very short period; we don't have a lot of data. To be fairer still, the past three years have been fairly tame. We haven't experienced the type of gut-wrenching drawdowns or volatility that these strategies were designed for. However, just to be sure I wasn't grading too harshly, I peeked over the fence to see how these ETPs' actively managed mutual fund peers (note that the two AdvisorShares ETFs and the PowerShares ETF are actively managed) have scored using these same criteria. Specifically, I looked at the lineup of Morningstar Medalists (funds that have been awarded a Morningstar Analyst Rating of Gold, Silver, or Bronze) in the same five categories. Interestingly, five of the 18 actively managed mutual funds made the grade. This can be partly attributed to selection bias: I looked exclusively at the medalists, our picks for best-of-breed in these categories. But I believe part of it also speaks to the value of employing a capable and experienced active manager to imple­ment these sorts of strategies.

There Are Rules
Eleven of the 14 ETPs I've examined here are index funds. Index funds generally have the benefit of being low-cost, transparent, and tax-efficient. But they also, by definition, must play by a set of rules: specifically, an index methodology. Deriving an index that mimics the returns of a universe of hedge funds is easy. Coming up with one that will continue to demonstrate the same characteristics it showed in a back-test is hard. In my mind, an index-based approach to repli­cating these strategies is likely to prove too ham-fisted to be useful. This is an area where, in my opinion, an actively managed fund is probably your best option.

My Favorites
Within our universe of rated liquid alternatives strate­gies, I have three favorites, all of which passed my test with flying colors. Below, I've summarized our analysts' opinion of each of them. Please note that these funds might be out of reach as they are either closed to new investors, accessible only through an advisor or 401(k) plan, or have high minimum investment requirements.

AQR Multi-Strategy Alternative ASAIX; Bronze Rating
AQR Multi-Strategy Alternative provides exposure to more than 60 "alternative betas" grouped into nine distinct strategies (for example, currency carry, merger spreads, value, and momentum factors). The fund maintains roughly equal risk allocations to its constit­uent strategies, with a 20% leeway up or down depending on the investment committee's conviction level. This leads to two significant consequences. For one, the fund takes a contrarian approach, as its risk-based equal-allocation mandate causes it to lighten up on outperforming strategies. In addition, sticking to this objective restricts capacity because it maintains consistent allocations to capacity-constrained substrategies (for example, arbitrage strategies). Both of these consequences ultimately benefit current investors with greater diversification.

AQR Style Premia Alternative QSPIX; Silver Rating
This strategy targets four well-established investment factors, also known as risk or style premiums (value, momentum, carry, and defensive). Each of the four factors is rooted in academic research, much of which has been conducted by AQR's principals and has historically generated long-term returns that have outpaced market-cap-weighted indexes. As those factors have become more well known, they are less likely to have as strong risk-adjusted returns going forward as they have historically. This portfolio's diversification across the factors, which have a low correlation to one another and across asset classes, should lead to more robust performance than any of the factors or asset classes on their own.

Vanguard Market Neutral VMNIX; Silver Rating
Funds in the market-neutral category make matching bets on long and short equity positions to isolate a manager's skill in picking stocks without taking on the overall market's risk. Vanguard's quantitative equity team takes a slightly different approach. Instead of pitting single stocks versus each other, the team's systematic process leads to bets on groups of stocks that score well on five factors—valuation, growth, quality, momentum, and management decisions (such as stock buybacks)—relative to industry peers. The process is designed to discover stocks within an industry that can grow earnings faster than peers but are trading at a discount. The short positions are the stocks that score poorest on the five factors. The long and short positions are balanced equally across each industry, and across company size, which has led to virtually no correlation to the S&P 500 since 2010, when Vanguard took over sole management of the fund.

Tayfun Icten and Jason Kephart contributed to this article. 

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Ben Johnson is Morningstar’s Director of European ETF Research.

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