Profiling Correlations, Part II: Alternative Strategies

Last month’s review of return correlations highlighted the challenge of finding strong diversification opportunities among the major asset classes for designing and managing portfolios. Does the landscape offer better choices if we expand the opportunity set by adding alternative strategies to the mix?

As a preliminary test, let’s compare a core set of the major asset classes with nine ETFs that offer something different from the standard fare. The list of funds below barely scratches the surface of what’s available for re-engineering conventional markets. For purposes of an initial test, however, these nine ETFs provide a reasonable starting point for considering the possibilities for diversifying portfolios.

IQ Merger Arbitrage (MNA)
WisdomTree Managed Futures Strategy (WTMF)
IQ Hedge Multi-Strategy Tracker (QAI)
ProShares RAFI Long/Short (RALS)
JPMorgan Diversified Alternative (JPHF)
PowerShares S&P 500 Low Volatility (SPLV)
Hull Tactical US (HTUS)
Global X JPMorgan US Sector Rotator (SCTO)
PowerShares DB G10 Currency Harvest (DBV)

The names above target a wide array of strategies, including mergers and acquisitions, long/short equity, managed futures, hedge fund-oriented strategies, US equity sector rotation, low volatility equity, and a multi-currency strategy designed to exploit what’s known as the carry trade: borrowing money in low-yielding currencies to invest in higher-yielding currencies.

The table below shows how the alternative funds compare with ETFs that represent the core set of the major asset classes (for a list of funds/tickers, see this post here), based on correlations via daily returns for the past 12 month through yesterday (April 3). The key takeaway: adding alternative ETFs expands the number of low and negative correlation pairs compared with limiting funds to the standard market choices.

Note, however, that many of the low and negative correlations are still linked with conventional bond funds. Indeed, the Vanguard Total Bond Market (BND), which tracks a broad measure of US investment-grade fixed-income securities, has low and negative correlations with most of the funds in this test. But the same can be said for two alternative products — ProShares RAFI Long/Short (RALS) and PowerShares DB G10 Currency Harvest (DBV).

Low and negative correlations alone aren’t always a silver bullet, of course. The trick is finding strategies that offer substantial diversification benefits vs. conventional stock and bond funds with the potential for earning healthy returns. That’s a higher hurdle. Two alternative ETFs, RALS and DBV, for example, have posted mild losses over the past three years while US stocks (VTI) are up nearly 10% on an annualized three-year basis and US bonds (BND) are ahead by roughly 1% a year.

The future could, of course, deliver more favorable results for alternatives, particularly if the conventional market indexes stumble. It’s worth pointing out, however, that risk and return profiles for alternative products run the gamut. In fact, some corners of the alternatives space have managed to post gains in recent history despite the relentless gains in plain-vanilla equities. The IQ Merger Arbitrage ETF (MNA), for instance, is ahead by 2.3% annualized over the past three years. Not exactly a barn burner, but the fund’s low and negative correlations with almost everything else presents an intriguing possibility for diversification.

What looks interesting to one investor may be unappealing to another in the realm of alternatives. Much depends on the particulars of the overall risk tolerance, investment horizon, and other factors. In short, you shouldn’t wade into the alternative strategy waters without doing your homework. That includes considering the risks, which starts with higher fees and a mixed record with results. Hedge fund strategies, for instance, have delivered disappointing performances in general in recent years.

In theory, a broader opportunity set offers a chance to enhance an asset allocation strategy’s diversification potential, which is to say lowering risk without cutting return or boosting performance with little or no extra risk. In practice, turning theory into real-world results isn’t easy. But if you’re inclined to at least consider this realm, the ETF landscape, along with alternative products via open-end mutual funds, provides an ever-expanding list of research possibilities.