For ETF investors seeking stability in a market hammered by rising inflation and interest rates, alternative investments are increasingly seen as a safe haven.
A recent Cerulli Associates report says more than two-thirds of advisers today are using alternatives – such as private equity, debt, real estate, royalties and infrastructure – to lessen volatility and reduce risk in falling markets.
The strategies, used for years by wealthy investors and portfolio managers, are now available to every investor, including through lower-cost exchange-traded funds (ETFs).
The number exploded after securities regulators changed rules in 2019, allowing for hedge-fund style ETFs, says Daniel Straus, director of ETFs and financial products research with National Bank of Canada Financial Markets in Toronto.
His firm recently tallied 39 alternative investment ETFs, including U.S.-dollar variants, available on Canadian exchanges across six general investment strategies such as credit-focused, equity-focused and market-neutral themes.
Alternative asset funds have generally performed poorly for more than a decade when compared to equities and fixed income funds, observes Mark Noble, executive vice-president of ETF strategy with Horizons ETFs Management (Canada) Inc. in Toronto.
That changed this year with the worrisome mix of soaring energy prices, inflation, and upwardly marching interest rates as central banks look to tame demand and prices. Investors are more open to alternatives as part of a broader portfolio mix.
“This year is a reminder, in a very stark way, that diversification extends beyond stocks and bonds and expose to non-correlated assets is probably something that you need to have as a long-term investor,” Mr. Noble says.
“A number of ETFs with alternative asset class exposure have done quite well,” he says. The surprisingly large alternative asset fund class includes liquid asset alternatives that can have sophisticated active futures and shorting strategies as well as those that focus on long-out-of-favor assets such as commodities.
“We have seen a lot of these assets do well primarily because of commodities. They are doing well because of inflation,” which can run up the cost of commodities whose prices are jacked up by higher extraction, supply chain disruptions and delivery costs such as we have seen this year.
Russia’s invasion of Ukraine has also highlighted that, despite a growing focus on renewable energy, economies have been getting by on for decades relatively cheap oil and natural gas.
Investor capital has been moving to alt ETFs. Mr. Noble estimates $500-million has shifted this year to the sector, with most going to a few of the largest funds.
His company’s best-known alternative fund, the Horizons ReSolve Adaptive Asset Allocation ETF (HRAA-T), invests in a globally diversified portfolio that aims to generate positive returns with low volatility and low correlation to the broader equity and fixed income markets.
It has a management expense ratio (MER) of 1.94 per cent and $147.6-million in assets. The hefty fee reflects the costs of the active strategy run by sub-advisor ReSolve Asset Management Inc. of Toronto, which specializes in liquid alternative investment strategies.
HRAA’s performance is flat so far this year, after returning 10-per-cent return in 2021. (All data is based on total returns from Morningstar as of Sep. 22 market close). By comparison, the S&P/TSX Composite Index is down nearly 10.5 per cent year to date and gained 25 per cent in 2021.
Other popular alt investment ETFs include the NBI Liquid Alternatives ETF (NALT-T) and the AGFiQ US Market Neutral Anti-Beta CAD Hedged (QBTL-T) and the Desjardins Alt Long/Short Equity Market Neutral Equity fund (DANC-T).
National Bank Investment’s NALT fund uses futures contracts to provide a positive return regardless of the conditions of global equity markets. It has an MER of 0.69 per cent, $286.9-million in assets with a 10-per cent return so far this year and 6.5 per cent in 2021.
AGF Investment’s QBTL seeks less volatility than the U.S. equity market by investing long positions in low beta equities and short positions in high beta U.S. equities. With an MER of 0.55 per cent and $295-million in assets, the strategy has paid off with a year to date return of 14 per cent. It lost 8.4 per cent in 2021.
The largest alt ETF in assets, DANC from Desjardins, charges 1.14 per cent and has $703.9-million in assets with a relatively flat performance this year and in 2021.
In terms of assets under management, the biggest player is CI Global Asset Management which offers liquid alternatives in both mutual funds and ETFs, with $3.7-billion in assets as of July 31.
CI, which offers four credit-focused ETFs, has “had some pockets of great performance” in that category, says Geraldo Ferreira, the firm’s Toronto-based senior vice-president and head of investment products and manager oversight.
“The performance has actually been quite good and significantly better than the broader benchmark,” he says.
He highlights the CI Alternative Diversified Opportunities Fund ETF (CMDO-T), which focuses on generating higher yields while managing interest rate risks. CMDO charges 1.08 per cent with $88.9-million in assets. It has dropped 4 per cent so far this year.
The appeal of liquid alternative ETF investors is understandable, he says, given their promise for lower volatility and downside risk, portfolio diversification by their lower correlation to stock and fixed income markets and potential for greater absolute and risk-adjusted returns.
“Those are the benefits from a liquid alternative but when you marry it with an ETF vehicle, there are further benefits for investors,” notably their liquidity and low investment minimums, says Mr. Ferreira.