5 Types of Alternative ETFs

Exchange-traded fund launches have exploded in recent years. In such a crowded marketplace, firms often wrap new products in sparkly packages to attract investors. Emerging types of ETFs aim to offer something different than mainstream assets.

When are alternative ETFs right for portfolios? What advantages are new, and what could be accomplished with traditional stocks and bonds?

With open discussions about alternatives, advisors can prove to clients that they’re on top of market developments.

Let’s get into the basics.

Alternative investment strategies try to expand, diversify, or eliminate the dominant risk factors of traditional stocks or bonds. In reality, those diversification benefits vary. (For a full breakdown by Morningstar category, download the full diversification landscape report.)

Many alternative strategies are restricted to hedge funds, reserved for accredited, high-net-worth investors.  Alternative ETFs offer a liquid way to tap into these strategies, hence the name liquid alts.

But alternative ETFs are still unfamiliar to many investors. In one survey, half of respondents couldn’t define alternative asset classes beyond crypto and commodities.

This merits caution. Alternatives need more manager moves to stay on top of long and short positions. Investors might have a hard time understanding their complex structure and need more education to manage expectations.

Here are a few of the new items on the menu.

Defined-outcome ETFs are an emerging subset of options-trading ETFs. These funds use options contracts to deliver a predefined range of outcomes over a set period. Predictable returns make it easier for investors to evaluate a product’s risk/return characteristics.

The Morningstar category covers 289 defined-outcome ETFs as of August 14, 2024. With the category tag in our database, investors can compare funds across data points like:

• Absolute and relative returns over custom periods.
• Underlying equity exposure.
• Annual fees.
• Investment strategy, based on the prospectus.

One example is 100% downside protection ETFs. These ETFs use options to provide a narrow range of returns within a specific period, from roughly 0% to an upside cap. The cap is higher than Treasury bills rate but much lower than what the stock market has historically achieved.

These strategies work best for capital preservation. The cost of downside protection is best justified for investors with short-term liquidity needs or a short investing horizon. Think people anticipating large purchases or retirees starting their withdrawal phase.

To date, only four providers have launched 100% downside protection ETFs.

Systematic trend strategies rely on trend-following price momentum signals. These strategies aim to capture trends in the market and take advantage of price movements. They can take long and short bets across futures on stock, bond, commodity, and currency markets around the world.

Systematic trend ETFs focus on absolute returns. They aim for positive returns in all markets and don’t share the same risk exposures as stocks and bonds. This results in low or negative correlation with the broad equity market, making it a compelling option as a diversifier for traditional stock/bond portfolios.

Today’s category offerings are all managed-futures ETFs. These funds generate returns by trading futures contracts, often including several contracts of up to hundreds of futures globally. They tap a straightforward formula: Buy what’s up, sell what’s down.

This simple strategy is head-scratching. The best explanation for why trend-following works is that investors react to new information too slowly. We’re slow to incorporate positive news that should increase prices or bad news that should decrease them. Trend-following takes advantage of human inefficiencies.

Managed-futures performance comes in fits and starts. Stretches of underperformance can make it difficult to stick with managed futures.

So far, managed futures ETFs are a small group. In the United States, the Morningstar Category includes eight ETFs with $2 billion in assets at the end of August 2024. Database users can compare funds against peers across data points such as:

• Absolute and relative returns over custom periods.
• Rolling correlations vs. a market index.
• Annual fee.
• Net fund flows.
• Underlying holdings information.

Event-driven ETFs aim to capitalize on security price changes due to corporate actions such as mergers, bankruptcies, and acquisitions.

These diversifiers typically have little to no sensitivity to move in equities markets. But tough economic headwinds can challenge event-driven funds. Because they rely on corporate activity to make money, they can suffer when mergers and acquisitions slow.

Morningstar covers seven event-driven ETFs, which held $395 million in assets as of August 14, 2024.

Digital asset portfolios invest most of their assets into one or more broadly classified areas:

• Decentralized Finance (DeFi) assets.
• Stable coins.
• Currency assets.
• Smart contracts platforms.
• Exchange assets.
• Privacy assets.
• Yield farming.
• Nonfungible tokens, or NFTs.

Portfolios may access digital assets through physical or derivative exposures. They can incorporate long-only investments and other hedging techniques.

After its January launch, the spot bitcoin ETF became the fastest-growing ETF class of all time. This year marked the first time that funds could invest directly in crypto, instead of tracking the price via futures. The 11 ETFs hold $53 billion in assets as of August 14, 2024.

Multistrategy portfolios offer investors exposure to two or more of Morningstar’s alternative investment strategies. At a minimum, alternatives must comprise greater than 30% of the strategy’s gross exposure.

Multistrategy funds typically aim to have low to modest sensitivity to traditional market indexes. However, that may not be the case for strategies with lower alternatives allocations.

Morningstar covers five multistrategy ETFs in the United States, with $939 million in net assets as of August 14, 2024.

Alternatives aren’t right for everyone. When advisors talk to clients about liquid alts, they need to provide clear explanations of asset classes. Generative AI tools can help to rephrase concepts to make them digestible to investors.

Compare alts against other investments that could suit their risk tolerance and goals. If it looks like behavioral biases, such as overconfidence, are affecting client decisions, bring the conversation back to their goals.

These discussions can help manage client expectations and lead to more open relationships.