Alternative ETFs gaining ground

Accessing alternative strategies through exchange-traded funds (ETFs), which typically invest in alternative products such as physical commodities or use various derivative or hedging strategies to achieve their objectives, is becoming increasingly popular among clients looking to manage risks and enhance the returns of their portfolios.

“We expect alternative ETFs to continue to grow rapidly over the coming decade,” says Som Seif, president and CEO of Purpose Investments Inc. in Toronto, “as more and more Canadians increase their exposure to alternatives and focus on risk- management strategies.”

As Howard Atkinson, president of Horizons ETFs Management (Canada) Inc. in Toronto notes: “The five-year-plus bull market in North American equities left many investors complacent about risk. Managing risk should be ongoing and paramount for investors. The time to diversify and manage risk is before a bear market, not afterward.”

And, Atkinson suggests, the market for alternative ETFs in Canada is underdeveloped. He cites statistics provided by Toronto-based Investor Economics, a division of U.S.-based research firm Asset International Inc., that indicate the $3.6 billion of assets under management (AUM) in “specialty ETFs” – which include covered calls, commodities, infrastructure, volatility, currency, hedge fund and managed futures strategies – grew by 11.7% for the one-year period ended March 31, 2014, and by a compound annual rate of 14.5% for the three-year period ended March 31.

ETF advantages

Although this is solid growth, it lagged mainstream ETFs, which grew by 18.2% and 20.6%, respectively, over the same periods.

Getting exposure to alternative strategies through ETFs has several advantages, particularly when compared with mutual and hedge funds – the other options available to clients looking for access to these strategies.

Unlike mutual funds, alternative ETFs have natural liquidity because they trade on stock exchanges, says Mark Raes, vice president and head of product with BMO Global Asset Management Inc. in Toronto. He notes that ETF investors do not have to deal with product providers, as do mutual fund investors, allowing ETF investors to make decisions about their holdings at times that are convenient to them.

And hedge funds charge management fees that, on average, are about 2% plus 20% of outperformance above a specified watermark; management fees for ETFs are less than 1% on average.

Atkinson notes that alternative ETFs have “intraday liquidity versus weekly, monthly or quarterly liquidity for hedge funds. Alternative strategies combine the low cost and transparency of ETFs, as well as provide diversification to traditional asset classes.”

It’s important for clients who invest in alternative ETFs, says Seif, to understand their ETF choices’ underlying strategy and how the money is being invested.

“When comparing alternative ETFs to traditional ETFs,” says Seif, “investors need to make sure they are comparing apples with apples and properly understand the underlying strategies, asset classes, risks and expected returns.”

Different performance

For example, he says, a hedged equities strategy generally will perform differently compared with the performance of a traditional equities index ETF during rising and declining markets.

The objective of alternative ETFs is not necessarily to beat a benchmark or an index; rather, the goal, says Raes, is to achieve a specific investment objective using an underlying asset class or strategy. An ETF that employs a covered-call strategy, for example, is designed to decrease the risk of stock ownership while providing additional income.

However, the covered-call strategy caps the upside potential of stocks but limits downside losses – a feature that is attractive to clients in today’s economic climate.

For example, BMO Covered Call Canadian Banks ETF provides exposure to a portfolio of Canadian banks while earning call-option premiums; BMO U.S. High Dividend Covered Call ETF provides exposure to a dividend-focused portfolio of stocks issued by U.S. banks while earning call-option premiums. (BMO Covered Call Canadian Banks ETF, says Raes, is BMO’s most successful ETF. )

Alternative ETFs, says Atkinson, “should continue to grow at recent growth rates but will get a dramatic boost from the next bear market in equities and/or bonds.

“Unfortunately,” he adds, “many investors will diversify into alternative strategies after the fact. Ideally, they should place 10%-20% of their portfolios into alternatives now for a much gentler ride in the next bear market.”

Covered-call ETFs, with $1.9 billion in AUM, represent the biggest slice of the $3.6-billion in total AUM held in alternative ETFs. Next in line are commodities-based ETFs, with $1.1 billion in AUM; then, infrastructure ETFs, with $236 million in AUM.IE

This is the final article in a three-part series on alternative investments.