Alternative investments, or simply alternatives, have become buzzwords in the industry, namely for their perceived benefits beyond traditional stocks and bonds. Alternatives range from highly liquid commodities to hedge funds and even nontraded vehicles that may not be investments at all. Not all investments can fit into the exchange-traded fund (ETF) wrapper; however, a subset of these alternatives dubbed “liquid alternatives” has seen a wave of issuance and growth in the ETF space. These typically include strategies such as managed futures, long/short, merger arbitrage and multistrategy funds, among others.
Many of these ETFs have come under scrutiny for their lack of effectiveness or liquidity. But if you stick to what I call the “three C’s of liquid alts” – correlation, comprehension, and cost – then you and your clients will likely have a better experience with alternative ETFs.
The entire goal of an alternative investment to traditional stocks and bonds is that it does not behave like traditional stocks and bonds. One of the best ways to measure that relationship is through correlation. Correlation measures how closely two securities move in relation to one another on a scale of negative 1 to 1. A correlation of zero shows no relationship between the two securities, with 1 being perfectly correlated and negative 1 being perfectly inverse. Generally, a correlation close to zero of an alternative ETF is preferred. Ideally, alternatives should perform when nothing else does, and correlation can help to identify those strategies. Typically, merger arbitrage, managed futures and some long/short strategies will have low and sometimes zero correlations. While correlation isn’t as readily available as some statistical measures, it is worth the extra digging.