Liquid Alternatives ETFs Haven't Delivered

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Have liquid alternative ETFs delivered on their promise? Joining me to discuss some research on this topic is Ben Johnson. He is director of global ETF research for Morningstar.

Ben, thank you so much for being here.

Ben Johnson: Thanks for having me, Christine.

Benz: Ben, before we get into your research, which was in ETFInvestor, let's talk about alternatives generally. What is an alternative investment, and why are investors interested in them as a portion of their portfolios?

Johnson: Well, I think, definitionally, alternatives are somewhat challenged in that what you call an alternative is still somewhat in the eye of the beholder. But how we tend to think of alternatives is, very simply, alternatives to stocks and bonds. And because we deem them alternatives to stocks and bonds, they are going to diversify away the risks that you would assume by taking positions in equities or taking positions in fixed-income securities. So, we would expect them to have a low to zero to negative degree of correlation with those other asset classes; we would still expect some sort of positive return out of them.

So, alternatives can include individual asset classes, say, commodities or currencies, depending on your definition. They can include different types of strategies that might be employed over stocks--say, a long-short equity where you're going long a certain basket of stocks, short a certain basket of stocks, taking the equity market risk out of the equation and trying to isolate your best ideas or trying to isolate stock picks that you think might actually depreciate in value, or what have you, all again with the end goal of diversifying both the stock and the bond risk that might already be present in your portfolio.

Benz: OK. So, let's discuss the explosion of products in this space. One of the key things that these products have had in common has been this focus on liquidity. So, the idea of providing some sort of alternative performance but also making it something that investors can get easily in and out of. Let's talk about why that liquidity piece has been desirable and in demand among investors who are looking at alternatives investments.

Johnson: The liquid in liquid alternatives is a feature that became in sort of hot demand following the financial crisis, again, where not only did people want this magic exposure but they wanted it in a format that they could come and go as they please. So, what we saw was that in the crisis many hedge funds--where many investors would typically have sought this sort of outcome--had lock-ups. So, there were investors who were panicked. They wanted to sell; they couldn't sell. And in many cases, that resulted in a near-guarantee of permanent capital impairment.

So, the liquidity feature, taking these same strategies and putting them into a mutual fund, putting them into an exchange-traded fund, delivers them in a way which is inherently miles more liquid than might be the case in a hedge fund format.

Benz: I guess, kind of, a Catch-22 though is that perhaps that illiquidity was a feature in helping some of these investment types, in the past at least, deliver on their promise?

Johnson: Absolutely. So, unlike the hedge fund format this liquidity demands that the actual constituents of those portfolios be liquid themselves. So, there's certain opportunities. In fact, a huge portion of the opportunity set that might be exploited by a savvy hedge fund manager plying their trade that are simply off limits for a mutual fund or an exchange-traded fund.

Benz: OK. You did some research where you looked at the performance of the liquid alt ETF universe, and you point out that it's early days for many of these products. But let's talk about what you found. You looked at their correlations with the equity market, with the bond market. Did the funds deliver that low correlation, no correlation that investors might look to an alternative product to provide?

Johnson: So, I looked at the universe of exchange-traded products that fall into our various alternatives categories, and I narrowed that down on the basis of just track record, frankly. We only have so much data given that these are relatively new.

So, we had 14 exchange-traded funds as well as a few exchange-traded notes that have at least three years worth of performance history, some of them five. And I put them to the test. So, will these funds, will these strategies diversify my equity risk, diversify my fixed-income risk, and importantly as well, earn some sort of positive return? You are not anticipating having a beta of one nor should you anticipate having a beta of one to either stocks nor bonds. So, it's not fair to expect S&P 500 returns from one of these strategies. But you expect something, and certainly not negative returns.

So, what I saw is, among these 14 funds--for which we have at least three years worth of performance history--is that 13 of the 14 failed on either one or both accounts. So, they were either very much positively correlated with either stocks or bonds, or if they had a low to negative degree of correlations with stocks or bonds, they posted returns that were less than bond returns--and I used an ETF proxy, an ETF that tracks the Barclays Ag as a proxy for bond return--or they had negative returns over that period. So, what we've seen to date is among the current crop of exchange-traded products that exist in these liquid alts categories, that they failed and in some cases, in spectacular fashion.

Benz: So, arguably, the specific time period that you examined was really favorable for equities. So, investors in practical terms really didn't need that diversifier. So, I assume you'd want to look for a little more history before saying, definitely thumbs down to this whole group, right?

Johnson: Two very important caveats. Obviously, three years is a very short period of time in the grand scheme of things. And to be fair, still the three years that are included are part of what is one of the longest bull runs in the history of the financial markets. So, we haven't seen the type of drawdown as we witnessed in the financial crisis, as we witnessed following the bursting of the tech bubble, where you would expect these strategies to prove their worth. So, the jury is probably still out, but the early signs are not encouraging.

Benz: Based on that it sounds like you're not too excited about this crop of liquid alt ETFs, but you are a little more sanguine about a few of the actively managed funds. Let's talk about that.

Johnson: I believe that this area, alternatives, is an area where active managers can add a good deal of value. In my opinion, many of the index approaches here are somewhat ham-fisted. It's easy to build an index that delivered on these two promises in a back-test. It's difficult and potentially impossible to build an index that on a go-forward basis will also deliver the goods.

So, if you look at our favorites in this space among the manager research group here at Morningstar, there are two that stand out in particular. So, if you look at the AQR Style Premia Alternative Fund, which has a Silver rating, and the Vanguard Market Neutral Fund, which also has a Silver rating, both of these funds pass both of the tests I described with flying colors over the trailing three-and five-year periods; low correlation with stocks and bonds, above bondlike returns.

These two funds have a bit in common. So, both are out to exploit factors like value and momentum, but they do so in a long-short context. So, they take that equity market risk, that beta out of the equation and look to get more pure expressions of value and momentum, combine these factors in a way that diversifies the risk of any one factor exposure, removes, again, that equity market beta, and I think is a far more sensible way to approach delivering on the promise of low correlations and positive returns, and one, given that it is an active strategy, can be refined and fine-tuned with time. And what we see in both cases is that the management teams at the helms of both of these funds have done exactly that.

Benz: Last question for you, Ben. Do you see some sort of an alternative investment as a must-have for investors, or if they have that core equity, core fixed-income position, are they OK with just those two building blocks?

Johnson: By no means do I think that exposure to any sort of alternative strategy is a must-have. If you look back over very long periods of time, stocks and bonds have done a very good job of diversifying one another. They are fundamentally different asset classes. This is not a requisite for anyone's portfolio. And I would advise anyone looking into adding one of these strategies to their portfolios to shop very carefully, to tread carefully and to look for best-of-breed funds from specialists with long track records. And again, it's an area where I think indexes are just inherently disadvantaged.

Benz: OK. Ben, interesting research. Thank you so much for being here to share it with us.

Johnson: Glad to be here.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.