DJ Alternative ETFs 2.0 Are Here, but Is It Too Late? -- Barrons.com

By Lewis Braham

Ever since the 2007-09 financial crisis, alternative exchange-traded funds have seemed like exotic failures. These ETFs -- designed to hedge against market downturns or provide portfolio diversification by behaving differently from stocks and bonds -- were celebrated after the crash, then largely ignored by investors in the great bull market that followed.

But once the 2020 pandemic slide began, a new crop of alternative ETFs was launched. Since the beginning of February 2020, 84 have opened, more than doubling the total to 146, according to Morningstar.

By far the biggest trend in alternative ETFs is the use of options: Of the 84 newest alt ETFs, 80 are in a new Morningstar category called Options Trading. Most, though not all, are "buffer" funds. Also known as defined-outcome ETFs, they use options -- derivative contracts on popular indexes such as the S&P 500 -- that limit how much investors lose when the index falls. The trade-off is that they also limit profits when it goes up.

These caps are established when the fund is launched. As the profit potential or loss protection is used up, the fund becomes less attractive. That's one reason that so many of these ETFs have been created and why many investors prefer newer issues. To get around this problem, some managers have issued buffer ETFs that reset annually, in the month marking the anniversary of their launch.

The websites of the largest issuers -- Innovator ETFs and First Trust -- identify the "remaining cap" and the "downside before buffer," which an investor can use to determine how much downside protection and upside potential each ETF still provides. The $317 million Innovator S&P 500 Power Buffer January Series (ticker: PJAN), for instance, had a 9.75% starting cap and a 15% starting buffer when it was issued. So, if the S&P 500 fell 15% or less from where it was at the ETF's launch, investors wouldn't incur any losses. They also wouldn't be able to reap gains beyond a 9.75% increase in the benchmark index from the date of launch. As of Sept. 23, after 2021's rally, the "remaining cap" on upside had shrunk to 1.5%, while the ETF still had 7.5% of downside exposure before the 15% buffer protection kicks in. These numbers can shift daily.

Some critics argue that the surge in alternative ETF issuance is too late. "The analogy I've often used is [the fund industry] comes knocking at your front door to sell you volcano insurance, while lava is melting your front stairs," says Ben Johnson, director of global ETF Research for Morningstar. "The opportunity cost has been absolutely massive for anybody who has been invested in one of these products over the course of the past year."

Yet for the right kind of investor, alt ETFs can make sense. Having downside protection can help the skittish stay invested and sleep at night. Moreover, in an environment where bonds pay practically nothing, investors are seeking substitutes for traditional 60% stock/40% bond portfolios. "If you compare these products simply to the S&P 500, they're completely different," says Bruce Bond, Innovator ETFs' CEO. "You're not taking the risk on the S&P 500, so you should not expect the kind of return you would get in the S&P 500."

More-flexible strategies may produce better results. The Swan Hedged Equity US Large Cap ETF (HEGD), launched in December 2020, has a similar S&P 500 options hedge, but is actively managed. Although it has always hedged somewhat, co-manager Micah Wakefield can adjust or rebalance its downside protection, depending on market conditions. In contrast, he points out, buffer ETFs generally hedge all or nothing -- offering complete protection in the buffer range and none outside it. "That's the Achilles' heel here, because once you blow past that protection layer, you've got open-ended risk," he says.

Although the Swan ETF is new, its managers have run hedged portfolios since 1997. The firm's Swan Defined Risk mutual fund (SDRIX) has outpaced comparable S&P 500 buffer ETFs -- those with a similar amount of downside protection -- since March 1, 2020. Another top-performing options mutual fund, JPMorgan Hedged Equity (JHQAX), also has beaten the buffer ETFs. It's closed to new investors, but its managers run a very similar fund that is open: JPMorgan Hedged Equity 2 (JHDAX).

A few different kinds of alternative ETFs are available, notably KFA Mount Lucas Index Strategy (KMLM), which uses derivatives to bet on trends in commodities, currencies, and bonds. Though the ETF is new, the benchmark it tracks -- the KFA MLM Index -- was designed by Mount Lucas Management for institutional investors more than 30 years ago. The benchmark produced an 8.9% annualized return from Jan. 1, 1988, through June 30, 2021, without stock investments. In contrast, the WisdomTree Managed Futures Strategy (WTMF), has been lackluster, with a minus 0.8% 10-year annualized return through Sept. 22.

The SPAC and New Issue ETF (SPCX), available since December, invests in special-purpose acquisition companies -- a hot area of the market. SPACs are often called blank-check companies because they are initially just a pile of cash that their managers use to acquire a private concern and take it public.

Sometimes, the manager is an investment luminary, such as billionaire venture capitalist Peter Thiel, whose Thiel Capital runs the Bridgetown Holdings SPAC (BTWN). The presence of a high-profile backer can help the shares trade at a premium to their underlying cash value, while a canceled deal can lead to a sharp discount to that value. SPACs, in other words, can be very volatile. The good news is that the SPAC and New Issue ETF is actively managed by Tuttle Capital Management, so it won't automatically buy whatever hot SPAC issues become available. The fund is off to a promising start, up 11% in 2021 through Sept. 22.

AltShares Merger Arbitrage (ARB), launched in May 2020, and First Trust Vivaldi Merger Arbitrage (MARB), launched in February of that year, are conventional low-volatility merger ETFs. The AltShares fund is based on a passive index at a time when increased regulatory scrutiny of mergers suggests that active management is preferable (see story on page S9). The First Trust fund is actively managed, but its 2.30% fees -- 1.25% expense ratio plus 1.05% for other hedging costs -- makes it no cheaper than a typical merger mutual fund. Moreover, its managers also run the Vivaldi Merger Arbitrage mutual fund (VARAX), which has a lower, 1.85% total expense ratio and is up 4.5% for the year as of Sept. 22, versus 0.9% for the ETF.

Merger ETFs aren't new. Two of the oldest are IQ Merger Arbitrage (MNA), launched in 2009, and ProShares Merger (MRGR), in 2012. Neither has had exciting returns in the post-2009 bull market: 3.6% annualized over the past decade for IQ Merger and 3.3% over the past five years for ProShares.

Bottom line: In a giddy bull market, it's hard to imagine that the 2.0 versions of these familiar arb strategies will interest investors more than their predecessors have.

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(END) Dow Jones Newswires

September 30, 2021 03:29 ET (07:29 GMT)

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