Liquid-alternative exchange traded funds (ETFs) comprise only a small part of the ETF universe. Estimated assets under management for the group are just about $2 billion, with roughly $1 billion of that total in the IQ Hedged Multi-Strategy Tracker ETF (QAI) from IndexIQ.
The investment options for this category are expanding, though.
In October, Morningstar teamed with ProShares to launch the ProShares Morningstar Alternatives Solution ETF (ALTS). It’s a still a very small fund with $19 million of AUM in mid-February, according to the Morningstar data. But it’s an interesting development that signals growing interest in the category.
What’s intriguing from a portfolio construction perspective is that the two funds include different asset classes in their portfolio weightings. That variation could provide additional flexibility when considering alternative ETFs for client portfolios.
Alt Fund Overview
IndexIQ’s QAI aims “to replicate the risk-adjusted return characteristics of hedge funds using various hedge fund investment styles, including long/short equity, global macro, market neutral, event-driven, fixed income arbitrage and emerging markets,” according to its website.
QAI’s top fund holdings (as of Feb. 12) are Vanguard Total Bond Market, 20.0% weight; PowerShares Senior Loan, 9.2%; Vanguard Short-term Bond ETF, 9.2%; iShares Russell 2000 Growth, 6.7%; and iShares Core U.S. Aggregate, 5.9%.
The Morningstar Diversified Alternatives Index, on which ALTS is based, “is designed to provide diversified exposure to alternative asset classes while enhancing risk-adjusted portfolio returns when combined with a range of traditional investments.”
It allocates its holdings among several ProShares alternative ETFs that employ a range of strategies: hedge fund strategies (strategic weight: 20%); long/short equity (18%); merger arbitrage (17%); managed futures (10%); breakeven inflation (10%); global infrastructure (9%) and listed private equity (16%).
Why use only ProShares funds?
According to John Faustino, head of product management for Morningstar’s indexes business, it was a pragmatic decision. ProShare’s lineup of liquid alt ETFs fit with Morningstar’s goal of creating an investible product “on top of the index” and ProShares was “well-suited to execute on that,” he says.
The ProShares funds used in the strategy include: RAF Long/Short (RALS), with a current weight of roughly 21%; Hedge Replication (HDG), 19%; Managed Futures Strategy (FUTS), 24%; DJ Brookfield Global Infrastructure (TOLZ), 15%; Merger (MRGR), 15%; Global Listed Private Equity (PEX), 2%; and 30 Year TIPS/TSY Spread (RINF), 3%.
Lucian Marinescu, portfolio manager with Morningstar Investment Management in Chicago, explains the strategic allocation is an attempt to include both risk-mitigating and return-enhancing funds.
The weighting decision begins with a forecast of each asset class’s expected returns, standard deviations and correlations. These inputs are used to optimize the weights of each holding.
The result is an attempt “to strike a balance and construct a diversified index of alternatives, in terms of representing both higher-beta alternatives and lower-beta alternatives that would be good complements — not only to equities but also to fixed income,” he says.
The strategic weights can be adjusted using what Morningstar describes as a “quantitative, rules-based momentum overlay.” That allows the fund manager to “emphasize certain asset classes depending on both the market environment and the momentum within those asset classes,” Marinescu says.
Cost and Performance
It’s common for multi-strategy liquid alts to charge annual fees in excess of 200 basis points. The ETF format funds are less expensive.
QAI has a total 0.91% annual expense, and ALTS’ fee is currently 0.95% with the fee waiver that runs thought Sept. 30, 2016.
ALTS’ short history and small size limit the significance of any performance figures. Still, through Jan. 31, the fund’s return is -0.10%, based on net asset value. QAI is up 0.31%.
(The Morningstar Diversified Alternatives Index is down 0.93% for the same period).
— Check out Three Myths About Liquid Alts on ThinkAdvisor.