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By Timothy Strauts

After lackluster equity returns in the past 10 years, many investors are increasing their allocations to alternative investments. The world of alternative investment strategies is quite broad, but it generally means an investment that offers diversification benefits to a traditional stock and bond portfolio. The alternative category has been steadily growing in popularity for the past decade, and demand has increased dramatically since the 2008 financial crisis. The alternatives mutual fund category has doubled in size since 2007 and today totals more than $98 billion. In the ETF space, real estate and commodities funds have been the primary alternative investments available, but in the past year new types of ETFs have launched that emulate strategies typically found in expensive hedge funds for wealthy investors. These new strategies give investors more options and may help them improve the risk-adjusted performance of their portfolios. We'll review three ETFs that seek to diversify returns and hedge downside risk.

Credit Suisse Merger Arbitrage Liquid Index ETN (NYSEARCA:CSMA)
Merger arbitrage is a strategy that seeks to capture the spread that often exists between the proposed offering price and the market price of a merger target's public stock. Merger arbitrage profits are the reward for acting as an insurer for the target's stockholders, who may wish to lock in their gains. The strategy can offer consistent returns but is prone to sharp losses during market panics when investors are concerned that proposed mergers may not go through because of stock market instability. CSMA is structured as an ETN and follows a rules-based quantitative strategy that attempts to gain exposure to a broad set of announced merger deals. By participating in all mergers that meet certain market-cap, liquidity, and other requirements, the ETF reduces the risk that any one merger falling through will have a large negative effect on the portfolio. The strategy is an attractive diversifier that has only a 0.37 correlation to the S&P 500 since 1998. The fund's back-tested return since 2001 was 6% annualized, with a 5% standard deviation.

CSMA does not use leverage like many hedge funds do and only charges an expense ratio of 0.55%, which makes it the cheapest fund available employing this strategy. Investors looking to allocate to merger arbitrage should take the funds from their fixed-income allocations. Merger arbitrage has similar risk and return characteristics to bonds and has only a 0.21 correlation to the Barclays Aggregate Bond Index, making it a good diversifier.

WisdomTree Managed Futures (NYSEARCA:WDTI)
Managed futures strategies take advantage of price trends across different futures contracts, using systematic, rules-based trading programs. The strategy will typically buy a futures contract if its price is in a positive trend and will short when its price is in a negative trend.

Managed futures strategies have the potential to produce positive returns in any market environment because of their ability to go long and short. The strategy will struggle during market turning points and directionless markets that move sideways because it needs a consistent trend up or down for its indicators to correctly go long or short. WDTI tracks the S&P Diversified Trends Indicator Index, which is a long/short futures strategy that invests in 24 liquid commodity and financial futures contracts.

Since 1985, using mostly back-tested data, the DTI index has had very strong annualized returns of 9.7% and a low standard deviation of 6.7%. If you look only at returns since the index was created in 2004, performance is not quite as good, with an annualized return of 5.6%. These lower returns can be attributed to the fact that the factors that performed best in the past often are not the same factors that outperform in the future. Also, managed futures strategies have become quite popular in the past five years, and large asset flows into strategies making similar trades have likely reduced overall returns of the group as a whole. This does not mean managed futures still couldn't fit into a portfolio today, but investors will need more-modest return expectations.

WDTI carries a fee of 0.95%, does not use leverage, and is registered under the Investment Company Act of 1940, which means the fund will issue 1099 tax forms and not the more complicated K-1s of some other funds. When allocating to managed futures, I suggest taking the funds from your equity or commodity portion of your portfolio.

Cambria Global Tactical ETF (NYSEARCA:GTAA)
Most funds with the goal of absolute returns employ various long/short strategies to get consistent low volatility returns. One downside to always shorting the market in some capacity is that it can limit returns during strong bull markets. GTAA takes a different approach to the goal of absolute returns by either going long an asset or holding cash. The strategy will never short and is sometimes called a long/flat strategy. The fund follows a rules-based, multi-asset, trend-following strategy that employs very wide diversification of holdings. GTAA will invest in U.S. stocks, international stocks, bonds, commodities, real estate, and foreign currencies all at the same time using ETFs. The broad multiasset diversification will help smooth out returns of any one asset class performing poorly.

The trend-following component of GTAA seeks to invest only in funds that are appreciating and avoid funds that are declining. It does this by using a fund's simple moving average as an indicator. For example, the 200-day SMA is a fund's average price during the past 200 trading days. An asset is in a positive trend when its market price is higher than the SMA. A basic strategy is to own the asset when it is above its 200-day SMA and to hold cash when it is below. Research shows that such a strategy avoids large losses in market crashes but can limit returns during market turning points. GTAA does not disclose exactly which SMAs it follows, but it is likely that it is using multiple SMAs to allow it to scale into and out of positions. It is possible that GTAA could move its entire portfolio to cash in a market crash if all investments were trading below their SMAs.

Since fund inception on Oct. 25, 2010, GTAA has returned 4.5%. This compares with a return of 10.06% for the S&P 500 and 1.44% for the Barclays Aggregate Bond Index. Based on GTAA's diverse combination of assets, it has performed about as expected. Since October, we have witnessed a strong bull market with very few changes in leading categories, so the risk-management capabilities of the strategy have not been used yet. Because GTAA owns such a diverse portfolio, it could be used as a core holding for someone who does not want to monitor and rebalance multiple funds and is looking for a strategy that can protect capital in bear markets.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Source: Three ETFs That Hedge and Diversify