iShares Diversified Alternatives Trust: Sound Concept, Strong Potential

Mar.29.11 | About: iShares Diversified (ALT)

In many ways, the iShares Diversified Alternatives Trust (NYSEARCA:ALT) is unlike any of the other iShares exchange traded funds.

By my count, there are 220 iShares ETFs covering everything from the MSCI Ireland Capped Investable Market Fund (NYSEARCA:EIRL), with just 23 holdings, to the Barclays Intermediate Credit Bond fund (NYSEARCA:CIU), with 1,364 corporate bonds.

In the midst of iShares' tremendous offerings is ALT - the only ETF that they offer that is actively managed - invests in multiple asset classes (stocks, bonds, currencies), doesn’t track a specific benchmark and provides direct exposure to ‘alternative’ strategies.

Despite the rapid growth in liquid alternatives, ALT currently has $127 million in assets and is a small fish in the $450 billion iShares pond.

Still, for investors seeking alternative strategies with potentially attractive risk/reward characteristics, ALT may be a good solution.

The fund prospectus states that ALT will target an annualized volatility between 6-8% and iShares expects a Sharpe Ratio of between 0.5 and 0.75 for the portfolio. With this data, we can infer expected returns between 3-6% over the risk-free rate (currently 0.10%).

Because the fund is essentially market neutral with short positions equally offsetting all of the long positions, the fund should remain relatively lowly correlated to stock and bonds returns.

Thus far, using whole month price data (except March) beginning October 31st, 2009 and March 25th, 2011, the realized correlation between ALT and the S&P 500 is 0.29 and 0.08 against the Barclays Aggregate Bond Index.

To generate these results, ALT uses three basic strategies in an effort to capture various risk premia. I am not aware of any other retail funds that explicitly try to capture various risk premia without taking systematic risks, although the concept is nicely illustrated in this MSCI Barra paper.

The MSCI Barra paper uses the small cap premium as an example, and essentially suggests going long small cap stocks and selling short large cap stocks to capture the small cap premium without taking market risk. Since the small cap premium isn’t evident all of the time, MSCI Barra argues that it is important to pursue multiple risk premia, like credit risk in fixed income or momentum in equity and currency markets.

iShares’ ALT pursues three strategies across three asset classes: stocks, bonds and currencies (the prospectus and marketing material also allow for commodities, although the fund has yet to take positions in this asset class). The three strategies include momentum, yield/curve arbitrage and fundamental relative value.

By pursing multiple strategies across several asset classes, ALT is very diversified, and holds more than 25 different futures contracts or currency forwards. Importantly, the fund is also weighted by risk, meaning that notional equity exposure is much smaller than the notional short-term bond exposure because stocks are more volatile than bonds.

Unfortunately, ALT hasn’t achieved its performance objectives to date. The fund is closing in on 17 complete months and the annualized return through March 25th is only 0.66%. The realized volatility has also been low, well below the 6-8% target with an annualized volatility of 3.7%.

The realized Sharpe Ratio is 0.18, below the 0.5-0.75 target outlined by iShares. During the same time period, the Sharpe Ratio for stocks was 1.21 and 1.38 for bonds.

Although the performance has been a disappointment, the concept is sound and what we have seen thus far is probably a function of the small data set (17 months) and relatively unique sample period.

In my view, ALT is definitely worthy of attention and is likely going to be an attractive solution for investors looking to earn bond-like returns with bond-like volatility, but that is uncorrelated to interest rates or equity markets.

At this point I think it makes sense to allow the fund more time to demonstrate the ‘proof of concept’ of risk premia investing; but with no obvious competitors, ALT is poised to attract assets when the performance catches up with the concept.

Disclosure: I am long ALT.

Disclaimer: The views expressed do not necessarily represent the views of Acropolis Investment Management, LLC. or its members.