From the March 2014 issue of Investment Advisor • Subscribe!

February 24, 2014

Long and Short: It’s Alts or Nothing

Alternative ETFs can help mitigate volatility

On a recent conference call, Morgan Creek Capital Management's Mark Yusko pointed to a forecast from GMO's Jeremy Grantham that for the next seven years, the S&P 500 is expected to produce negative real returns.

The good news is that GMO also predicted positive real returns for emerging markets and commodities. Sometimes investing in traditional areas expected to provide the highest returns requires stomaching volatility. One way to reduce that volatility is with an alternative approach.

First, let's remove misconceptions that alternative investments work both in bull and bear markets. While that may be the objective for some strategies, better long-term risk-adjusted returns remain the overall goal. This can be accomplished through a variety of ETFs such as market- or beta-neutral, dollar-neutral or relative-value, long-short and any form of either long or short bias.

Among the most popular alternative ETFs are inverse and leveraged beta products. These funds shouldn't be characterized as alternative solutions but rather as tools to accomplish an alternative approach. Despite existing negative feedback about the daily reset on leveraged ETFs—both long and short versions—such strategies work exactly as intended, although they should be used with a sophisticated model designed to incorporate the daily reset.

If searching for a do-it-yourself solution, then consider using a single beta inverse ETF as a hedge, but make sure a plan is in place when adjusting exposure, such as using a 50- or 200-day crossover signal that helps guide the hedging position's size. Other options include actively managed equity short ETFs that can be used similarly to single beta inverse strategies, but with the goal to obtain shorting alpha through the manager's individual stock selection.

Selecting an appropriate strategy depends on what is needed for a portfolio. Closely observing long-short ETF allocation is essential, as it's possible to have more market or long beta exposure than expected. Incorporating market-neutral or dollar-neutral strategies can lower overall portfolio volatility and beta. Active ETFs can offer both aggregate manager replication and single manager strategies too.

Note well that the liquidity of alternative ETFs is determined by, and should be measured by, their underlying securities. Most strategies are very liquid, but call the ETF sponsor to find liquidity on either side of an alternative ETF trade.

Now, let's consider fees. Avoid paying a lot for alternative beta, but expect higher management fees if incorporating an active approach. ETFs that include a direct shorting solution for all or part of the strategy may contain an additional fee described as “short interest expense,” which will drag on returns. The fee is not charged by the ETF manager, but is similar to a commission undisclosed for most funds (although it can be mentioned in an annual or semi-annual report). This unavoidable expense must be disclosed per the SEC. A short fund that uses derivatives or swaps usually does not disclose the short interest expense fee, but rest assured, it's embedded in the cost of the derivative.

In a higher interest rate environment, a true short strategy might have positive short interest income. Most funds pay an institutional borrowing rate of Libor minus X, meaning a lower amount that typically depends on what and how much a fund is borrowing. If short interest income does surface, SEC rules preclude ETF sponsors from listing it as a reduction in expense.

Sound advice is to emulate what the smart money is doing. Most that have wealth are not interested in swinging for the fences, but are attracted to hitting singles. Most institutions are increasing their allocations to alternatives because big losses take exponentially bigger gains for recovery. ETFs can provide the liquid tools needed to add alternatives to a client's portfolio.

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