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ETFs Turn Exotic – Protect yourself

October 17th, 2011

Investments that do not move in tandem with U.S. stocks present opportunities for diversification and potential performance enhancement.

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Summary Points

  • Exchange-traded funds (ETFs) are a convenient vehicle for accessing a variety of investments other than stocks.
  • Alternative investments include hedge funds, commodities, derivatives, and real estate.
  • In addition, there are alternative investment strategies that encompass short selling, arbitrage, leverage, and futures.

Of the top-selling ETF strategies to emerge on the scene in 2011, many present investors with choices other than U.S. equities. For instance, an ETF investing in Asian debt topped the list of launches with $470.98 million in net flows as of June 30, while a managed futures strategy fund came in second with $192.72 million in net assets.1 Other funds making the top ten include an ETF investing in senior loans and a fund investing in real estate investment trusts (REITs).1

What’s behind investors’ attraction to these more sophisticated, and in some cases more risky, investment choices? People are looking for something besides a plain vanilla fund, something that puts them outside the universe of U.S. Treasuries and domestic equities. They are looking to diversify their portfolios globally as well as thematically via commodities, emerging market debt, and hedging strategies such as managed futures. Managed futures funds invest in listed futures and options to benefit from expected trends in commodity prices, interest rates, or currency exchange markets.

What’s driving investors’ attraction to the exotic is a desire for investments that historically have not moved in tandem with U.S. stocks.This tendency to move (or not move) in tandem with another investment is measured by a statistic known as correlation. Although there are no guarantees, assets that historically have not moved in tandem with U.S. stocks could help to limit losses when U.S. stocks are in a slump.

Observed one industry analyst: “The alternatives theme is really resonating with people right now, and managed futures was one of the few hedge fund strategies that not only held up but also performed well during the global financial crisis.”1

Given the realities of today’s financial markets, it is notable that investors are moving a bit out of their comfort zones in search of performance. That fact undoubtedly warms the hearts of ETF innovators who are busy targeting corners of the market that have thus far been underrepresented.

What Makes an Investment “Alternative”?

Once exclusively the province of hedge funds and other institutional investors, alternative investments increasingly are becoming available to individuals. What alternative investments bring to the table is the opportunity for investors to gain exposure to an added layer of portfolio diversification and potential performance enhancement. The diversification and potential performance benefit stem both from the type of investment and from the strategy that an investment manager follows.

Alternative investments include hedge funds, commodities, derivatives, and real estate. In addition, investment managers also use innovative strategies, such as short selling, arbitrage, leverage, and futures, in an attempt to achieve a given objective.

  • Short selling occurs when an investor borrows shares to sell, with the goal of buying them back later at a lower price and pocketing the difference. Investors short shares of a security when they believe the price will fall, although there is no guarantee this will happen.
  • Arbitrage is an attempt to capitalize on market inefficiencies by simultaneously purchasing and selling an identical or similar investment on different markets or in different forms. Arbitrage is a difficult strategy to execute because market inefficiencies often are eliminated very quickly.
  • Leverage involves use of borrowed funds to enhance returns. Examples of leverage include options, futures, and margin accounts.
  • Futures contracts represent agreements between two parties to trade a commodity, financial instrument, or currency at a fixed price at some future date. Futures can be used to hedge against the risk of price moves or to profit from price speculation.

Managers using alternative strategies typically seek to generate returns that exceed or that do not move in tandem with a market benchmark.

Alternative investments and alternative investment strategies have gone mainstream. Widely available vehicles such as ETFs are among the most popular ways for investors to add this component to a portfolio.

Before investing in an ETF, be sure to carefully consider the fund’s objectives, risks, charges, and expenses. For a prospectus containing this and other important information, please click on the prospectus link. Please read the prospectus carefully before investing. ETFs are baskets of securities that may track a sector-specific, country-specific, or a narrow/broad market index. ETFs trade on an exchange like a stock. ETFs are subject to risks similar to those of their underlying securities, including, but not limited to, market, sector, or industry risks, and those regarding short selling and margin account maintenance. Commission fees typically apply.

Diversification does not assure a profit or protect against loss.

Investments in REITs are subject to the risks related to direct investment in real estate, such as real estate risk, regulatory risks, concentration risk, and diversification risk.

Alternative investments — These provide investors with exposure to markets and investment strategies that cannot be accessed through traditional fixed-income and equity markets (such as real estate, commodity, or natural resources). Investing in these investments is speculative, not suitable for all clients, and intended for experienced and sophisticated investors who are willing to bear the high economic risks of the investments.

1Source: Investment News, “The top-selling ETF strategies? Investors seeking risk for reward,” July 17, 2011.

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ETFs Turn Exotic – Protect yourself

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Commodities, ETF, OPTIONS, Real Estate, Uncategorized



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