You know, with all the political mishegas at the end of 2016, I let some things slip. It took a shout out from an old acquaintance to remind me that I’d failed to publish the year-end scorecard of the best and worst in alternative investment ETFs.
Herein I offer recompense for my senior moment. In fact, I’ll even pay it forward a bit. We won’t just provide the 2016 recap, we’ll also score the field into 2017’s first quarter.
If you’ve seen our previous scorecards (“Alternative ETFs 2015 Scorecard,” and “The Best and the Worst in Alternative Investment ETFs,”) you know we look at the performance of single ETFs which we feel best represent each alternative asset class or strategy. We’re not grading every fund in each category, so we urge readers considering alternative investment ETFs to look at all offerings to determine their suitability.
Alternative investments are supposed to diversify overall portfolio risk by providing uncorrelated returns. Ideally, adding an alternative allocation to more traditional investment exposures enhances returns and reduces volatility. Keep that word “ideally” in mind. Investments are cyclical — favored at times, shunned at others. No investment is riskless.
In our previous annual recaps, we ranked each asset class or strategy by its yearly return. We’ve seen some dramatic turnarounds from one year to the next. In 2014, for example, the proxy for “Equity Market Neutral — Momentum” was at the bottom of the performance table, but topped the list in 2015. And in 2016? Back to the bottom again. Caveat emptor.
Last Year’s Rankings
We’ve made a few changes to the table since it was last published. First of all, we’ve added two strategies — “Equity Long/Short” and “Multifactor Equity” in recognition of the asset growth enjoyed by their representative ETFs. We’re also ordering the table by Sharpe ratio now, though we still show rank by returns. We feel the Sharpe ratio — a measure of risk-adjusted return — better reflects the actual portfolio impact of an alternative investment exposure.
One thing you’ll first note about the 2016 results is that only two strategies, Multifactor Equity and Equity Market Neutral - Value, outdid the broader market return proxied by the SPDR S&P 500 ETF (NYSE Arca: SPY). That’s half the number in the previous year.
Three ETFs exhibited negative correlation to SPY, but only one — the SPDR Gold Trust NYSE (Arca: GLD) — did so while generating positive returns. Overall, alternative ETFs showed a middling correlation to the broad stock market.
By and large, alternative strategies were less volatile than the equity market, but because their returns were generally modest, only three exposures earned market-beating Sharpe ratios.
In 2016, the best return (16.80 percent) was snagged by the fund typifying Multifactor Equity. The FlexShares Morningstar U.S. Market Factor Tilt Index Fund (NYSE Arca: TILT) is the oldest multifactor ETF and, in fact, pretty much owns the category by dint of its size. The fund attempts to “tilt” its broad market portfolio toward small-cap and value exposure — hence its multifactor characterization — while minimizing tracking error. Its outsized return was accompanied by greater-than-benchmark volatility, so TILT’s Sharpe ratio is only marginally better than SPY’s.
Value, epitomized by the QuantShares U.S. Market Neutral Value ETF (NYSE Arca: CHEP), earned 2016’s penultimate return (13.52 percent) with modest correlation to the broad market. CHEP captures the spread between value and growth stocks with its long/short methodology.
The best risk-adjusted performance of the year — a Sharpe ratio double that of SPY’s — was turned in by the First Trust Tactical High Yield ETF (Nasdaq: HYLS) which follows a “130/30” strategy. HYLS managers lever long bets with the proceeds obtained by shorting issues expected to underperform. Among the top five performers over the past three years, HYLS has been the most consistent ETF in the field.
The methodology underlying the PowerShares DB G10 Currency Harvest ETF (NYSE Arca: DBV) mechanistically takes long positions in higher-yielding currencies and short positions in currencies earning low rates. In 2016, DBV delivered high risk-adjusted returns together with low correlation to equities.
Alpha Anyone?
You might expect that ETFs earning the greatest returns would garner more alpha. And you’d be right, to a degree. Among the equity-focused ETFs, three went positive in the alpha department. Keep in mind that alpha represents excess risk-adjusted returns, so it’s not gross returns that indicate alpha; it’s really a fund’s Sharpe ratio.
And now, 2017
Over the first three months of 2017, there’s been a significant shift in the alternatives market. Given the limited number of data points, we shouldn’t put too much stock in the raw numbers since they’ll change as the year unfolds. It’s the jockeying in table positions that’s telling. This year, domestic market factor strategies (momentum, value and size) have all fallen to the bottom, while less beta-dependent tactics (merger arbitrage, private equity and hedged equity) are ascendant.
Going into the second quarter, we’re seeing a rise in perceived tail risk and a resurgence in correlation. A black swan event — a decline two or three standard deviations deep — could greatly reorder the table.
One Last Note
Alternative investments, by and large, aren’t cheap. The average annual expense for the ETFs in our table is 95 basis points (0.95 percent). A few cost more than 200 basis points; the cheapest dings investors 25 bips.
The expense ratio is a performance hurdle that must be overcome before a fund’s benefits can be enjoyed. At 25 basis points, the hurdle’s very low for the FlexShares TILT portfolio. Given its tracking error, the TILT needs to appreciate 46 basis points to earn its fee. The AdvisorShares QAM Equity Hedge ETF (NYSE Arca: QEH), with its 203 basis point expense ratio and more substantial active risk, needs to gain 352 basis points to justify its cost.
Hopefully, my calendar won’t be so cluttered at the end of this year, so I can get a timely scorecard published. If I fail, feel free to give me a shout.
Brad Zigler is WealthManagement's Alternative Investments Editor. Previously, he was the head of Marketing, Research and Education for the Pacific Exchange's (now NYSE Arca) option market and the iShares complex of exchange traded funds.