Liquidity Makes Alternative ETFs Less Peculiar

May. 5.14 | About: IQ Hedge (QAI)

Increasingly, clients and prospective clients have been asking me about "liquid alternatives." On the one hand, I like the thinking behind an inquiry where the liquidity of an investment is at the forefront of a consideration. Alternative assets (e.g., art, wine, commercial real estate, commodities, etc.) often sound intriguing on the surface, but unless one is able to convert the asset to cash easily, gains can erode and financial hardships can ensue. It follows that assets in the alternative space tend to work best when the asset is liquidated at a desirable time at a desirable price.

On the other hand, few of the "liquid alts" that trade on market-based exchanges today have been around long enough to establish venerable track records. Long-short funds, 130/30s, absolute return strategies, hedge fund tracking, real return products, merger arbitrage, commodity plays - the vast majority have looked markedly weak next to traditional stocks and bonds. For example, IQ Hedge Multi-Strategy Tracker (NYSEARCA:QAI) is one of the most popular alternative ETFs over the previous three years. When compared to the S&P 500 SPDR Trust (NYSEARCA:SPY), though, QAI's relative strength via the QAI:SPY price ratio lacks inspiration.

QAI SPY price ratio 3 Years

With the exception of the heyday for the Eurozone's sovereign debt crisis (July-October, 2011), IQ Hedge Multi-Strategy Tracker has spent most of its time on the defensive. Some might even argue that the vehicle has been a dud. Still, its performance in the unstoppable stock market bull has been more impressive than a more traditional risk-off asset, the iShares Core Total U.S. Bond Market (NYSEARCA:AGG).

QAI AGG SPY 3 Years

Is it reasonable to presume that QAI could provide value if the stock bull stumbles? Granted, bonds traditionally cushion the blow of a downtrend for equities. However, the 10-year bond yields a meager 2.6%, while its spread with the 30-year is only 75 basis points. Bonds might struggle themselves. Meanwhile, U.S. stocks have been dancing near all-time records on questionable valuations. Now add global geopolitical risks from the Ukraine to the Middle East. Suddenly, diversifying into strategic vehicles that may hedge against stock-bond risk sounds like a reasonable pursuit.

Depending on one's perspective, QAI is achieving exactly what it is supposed to be achieving, or it has over-promised and under-delivered. I like the fact that QAI has a low correlation with the S&P 500; that is what diversification is all about. I also admire the low beta volatility of just 0.3. Additionally, I like the concept of gaining access to popular hedge fund strategies, including, but not limited to, long/short equity, fixed-income arbitrage and market neutrality.

Nevertheless, QAI's performance may be falling short of its stated goal to replicate the risk-adjusted returns of hedge fund performance. While that data on average "risk-adjusted" performance for hedge funds is not readily available, let alone multi-strategy hedge fund data, the 5-year total return of 21% appears inadequate. QAI costs 0.94% annually. Even at three-tenths the risk of traditional U.S. stocks, one should have been able to anticipate something a little more robust in the way of upside success.

Should you still consider a fund like IQ Hedge Multi-Strategy Tracker even though it may not be able to adequately replicate the return profile of unconstrained hedge funds? Perhaps. Liquidity, diversification and the possibility of partially swapping out a standard fixed income holding may add a sleep-at-night element that is not present in a typical stock-bond mix.

Past performance cannot predict future performance. When we hear that, we usually think that we have been warned that a super-sized performer could falter in the future. Yet, couldn't the opposite occur as well? Multi-strategy alternative funds may have provided low reward with low risk previously, but they might be able to increase the reward potential for the low level of risk going forward; that is, a fund like QAI may still have the potential in the future to provide far better returns with the same low level of risk that currently exists.

Remember, alternative investments (e.g., commodities, currencies, etc.) and alternative strategies (e.g., absolute return, market neutral, etc.) move independently of traditional stock and bond investments. Again, where it is possible for overvalued stocks and manipulated bonds to severely underachieve, some folks may want to commit a portion of their respective pies elsewhere. Just don't allocate the entire caboodle.

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Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationships.