Mutual funds and exchange-traded funds that offer alternative strategies to traditional stock and bond blends are touted as providing extra diversification and protection to a portfolio. The recent tariff-driven selloff offered a window into how these investments perform in times of market stress.
In recent years, alternative strategies have proliferated among ETFs, especially so-called buffer funds, which use call options to offer an assured return within a restricted band in exchange for downside protection against market declines. On the upside, return is capped.
April saw the steepest loss for both the S&P 500 and S&P/TSX Composite indexes. In one week, from April 2 to April 8, the S&P slid by 12% from 5,671 to 4,983, but it recaptured part of that loss by the end of the month, rising back to 5,569. This translated to a loss of 4.57% for the month in Canadian dollars. As of the end of April, the index had dropped by 8.7% since the beginning of the year. The S&P/TSX Composite Index followed a similar slant in April, dropping by 11.00% in the first week, then picking up to register a loss of only 0.97% for the month and 1.40% for the year.
Nine Canadian buffer ETFs did better than the S&P 500 (their reference index) in April. Their returns range from a loss of 0.5% for the BMO US Equity Buffer Hedged to CAD ETF – July ZJUL to a loss of 1.4% for the FT Vest US Equity Buffer ETF – May MAYB.F. Meanwhile, the Vanguard S&P 500 Index ETF VFV lost just shy of 5%.
The performance of buffer ETFs depends on their underlying securities, according to Monringstar manager research analyst Lan Ahn Tran. “They have generally performed as promised, falling less than their underlying,” she says. She advises that to benefit from its downside protection, an investor would do better to buy a buffer ETF at inception and keep it for its full holding period, which is usually a year.
“If you buy it outside the beginning period, you might not get the full protection,” Tran says. “Let’s say an ETF sells for $100 at inception in January. If the index goes down to $90 and you buy it at $95 in February, you will be covered only down to $90. So there’s an element of timing in buying, which does not usually work well for people.”
Liquid Alts Shine Unevenly
Liquid alt funds have behaved much like buffer ETFs. Second Engine, a subsidiary of asset manager Picton Mahoney, has assembled 11 indexes that track liquid alt strategies, like Equity Long/Short, Absolute Return, Event-Driven, Global Macro, and Equity Enhancer.
The performances of these indexes all fit in between the return paths of the S&P 500 and S&P/TSX, their returns for the month of April settling between a loss of 0.4% for the Equity Long Short Index and 1.7% for the Multi-Strategy Index. There were two outliers: The Global Macro Index was down 4.6%, while the Event-Driven Index delivered a positive performance of 1.0%.
Jason Kephart, senior principal, multi-asset strategy ratings at Morningstar, observed nearly similar results in the United States. But there are equity market neutral strategies that fared better during a different period: Feb. 19 through April 8. Of the nine categories which Morningstar tracks, only the equity market neutral strategy has been positive, with a 1.58% return. All the other categories have come in negative, from a 0.87% loss for relative value arbitrage to a 10.22% loss for long-short equity.
However, on the equity side, all categories have ensured a quite solid downside protection, considering that the Morningstar US Market index registered a 19.14% retreat for the same period.
Unlike buffer ETFs, liquid alternatives are not capped on the upside. However, they show little vigor on the uptake when markets pick up. For example, for the year to date through April 30, about half of Second Engine’s indexes beat the S&P 500, and none did better than the S&P/TSX Composite, except the Event-Driven Index, which gained 2.4%.
Whether investors compare the performance of a liquid alternative against the S&P 500 or a bond index will very much depend on the goal assigned to your fund. “Their impact on a portfolio depends largely on whether an investor uses them as substitutes for stocks, bonds, or cash,” Kephart notes.
Robert Wilson, head of innovation and portfolio strategist at Picton Mahoney, proposes a goal-based framework to select liquid alts for a portfolio. “We believe liquid alternatives should help investors achieve their goals with greater certainty,” he says. For example, if the aim is to mitigate risk, that would point toward a long short equity fund to reduce risk linked to stocks, or a long short credit fund to reduce risk-linked bonds. To diversify a portfolio even further and lower its correlation with stocks, an investors could select a merger arbitrage fund or a market neutral equity fund.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.
