ETFs For Alternative Asset Classes

By Aaron Levitt | February 25, 2013 AAA

With the financial crisis still fresh in the heads of many investors, many individuals and money managers are beginning to think about portfolio construction in a different light. Many are now questioning whether holding basic stock funds like the Vanguard Total Stock Market ETF (ARCA:VTI) are enough to see themselves through into their golden years. Burned by losses incurred over of the last few years, many are now turning towards alternative strategies to generate returns.

Following the lead of institutional investors, endowments and hedge funds, individual's portfolios are filling up with unique asset classes and allocations. Commodities, 130/30 tactics, long-short strategies and even non-traditional fixed-income securities are now prevalent in many portfolios.

The key to rising alternative asset class and strategy adoption has been the torrid growth of exchange traded funds (ETFs).

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Made for Sleek New Strategies

As ETFs have gained traction with regular retail investors, the size of the product lineup has grown rapidly. What started out as a few hundred funds offering exposure to "plain vanilla" stock and bond indexes - like the S&P 500 - has quickly grown to more than $2 trillion dollars in assets under management. Currently, there are now more than 4,766 different exchange traded products available to investors across the globe.

This proliferation of ETFs covering virtually every corner of the investable universe has given regular Joe investors tools that are more precise for accessing not only traditional stocks and bonds, but investment strategies and asset classes that were previously either out-of-reach or required huge expenses to implement properly. ETFs that provide access to alternative investments can deliver cost efficiency, liquidity and transparency not found in these alternatives more "traditional forms."

For example, hedge funds continue to produce market beating returns for their high net worth clients. Typically a hedge fund will work on the "2 and 20" pay scheme. That basically means, you will pay the hedge fund 2% a year for managing your money and then pay a 20% performance fee on your profits. For a mere 0.95% in expenses, investors can tap the ProShares Hedge Replication ETF (ARCA:HDG). That ETF tracks the performance of the Merrill Lynch Factor Model-Exchange Series- which is a standard measurement of hedge fund performance. By using the ETF, investors win on the fee-front. Not to mention the lack of a high minimum investment and the absence of a capital lock-up period.

However, this isn't the only example. Purchasing municipal bonds such as variable rate demand offerings often carry huge upfront investments - around $100,000 per issue. By using ETFs, investors once again can tap the structure. Likewise, merger arbitrage, bear market strategies and even timber management organizations can be tapped using the fund-type.

SEE: The Benefits Of ETF Investing

Adding a Swath of Alternatives

Depending on what advice you want to follow, many financial planners suggest you allocate anywhere from 5 to 30% of your portfolio to alternatives. ETFs can make that allocation as easy as placing a trade.

A good place to start - as it contains two of the most popular alt ETFs - is managed futures. At its core, managed futures strategies take advantage of price trends across different futures contracts including commodities, bonds, currencies and stock index derivatives. The idea is to create consistent positive returns in any market cycle. Both the WisdomTree Managed Futures (ARCA:WDTI) and iShares Diversified Alternatives Trust (ARCA:ALT) allow investors to tap into the strategy. The funds charge 0.96 and 0.95%, respectively. Again this is quite cheap considering that the average manage futures fund typically engages in the "2 and 20" style fee scheme. Both funds have managed to produce uncorrelated returns versus stocks and bonds since their inceptions. For investors, the ETF pair could be a good place to start on their alternatives weightings.

Another popular alternative tactic is bear market protection. By using ETFS, investors have the ability to engage in various shorting tactics without having to borrow shares or use margin. The Direxion Daily Total Market Bear 1X Shares (ARCA:TOTS) makes an ideal hedge against the broad market. While the ProShares Large Cap Core Plus (ARCA:CSM) and Credit Suisse Long/Short Liquid Index ETN (ARCA:CSLS) offer long-short transactions within one ticker.

SEE: Exchange-Traded Funds: ETF Alternative Investments

The Bottom Line

Whatever the alternative strategy you pick, ETFs can help you add that asset class or approach cheaply and easily. The continued growth in ETF adoption will only help strengthen the funds structure for these assets outside of bonds and stocks. The previous ideas are just some of the many ways ETFs are changing the landscape for regular retail investors.

At the time of writing, Aaron Levitt did not own any shares in any company mentioned in this article.

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