All told, last week was a pretty good one for alternative investments, otherwise known as “alts.” Not that it was a bad week for the broad equity market, mind you. The S&P 500, proxied by the SPDR S&P 500 ETF (NYSE Arca: SPY), gained more than 3%. Still, three alts ETFs outdid SPY in the week leading up to Memorial Day:
- Alerian MLP ETF (NYSE Arca: AMLP), which tracks a cap-weighted index of energy infrastructure master limited partnerships;
- Vanguard Real Estate Index ETF (NYSE Arca: VNQ), based on the MSCI Investable Market Real Estate 25/50 Index, covers a broad swath of companies engaged in ownership and operation of U.S. real estate, and
- SPDR Bloomberg Barclays Convertible Securities ETF (NYSE Arca: CWB), a market-value-weighted portfolio tracking large issues of convertible preferred shares and bonds.
The median weekly gain for the two dozen alts ETFs in the table was 1.23%. Only four funds ended the week in the red. For the year, 10 alts portfolios are outperforming the SPY fund, though only three are actually in positive territory. Most notably, the SPDR Gold Trust (NYSE Arca: GLD) has racked up a 14.21% gain since the top of the year as investors dove en masse into the noncorrelated pool. Year to date, the fund has netted an inflow of $11.76 billion.
For the week, the gold trust’s net inflow was rather modest: just 0.68% of its current asset base. Several ETFs enjoyed larger proportionate inflows. The standout, at 12.09%, is the First Trust Long/Short Equity ETF (NYSE Arca: FTLS). As its name suggests, the fund’s portfolio comprises short and long stock positions—typically 90% to 100% long and 0 to 50%vshort. That leaves the portfolio long beta—presently 0.57—and fairly well correlated, at 0.95, to the broad equity market.
It’s no wonder FTLS bestows a diversification benefit of only 2. The benefit represents the premium earned by adding the alt ETF to a balanced portfolio consisting of SPY and the iShares Core U.S. Aggregate Bond ETF (NYSE Arca: AGG).
If one assumes diversification to be a reduction in the risk of holding a portfolio, then additional exposures should be sought that result in a decline in overall portfolio volatility. The diversification ratio of a balanced portfolio—60% SPY and 40% AGG—is 1.15, derived by dividing the weighted sum of SPY’s and AGG’s standard deviations by the volatility of the combined SPY/AGG portfolio. In this case, SPY earned a 16.45% annualized standard deviation over the past three years while AGG clocked in at 3.39%. The ETFs’ weighted volatilities add up to 11.23%. When combined in the portfolio, however, the balanced asset mix tips the volatility scale at just 9.75%. The diversification ratio, thus, is 11.23 ÷ 9.75, or 1.15.
If a 10% carve-out from the SPY allocation makes room for an alt ETF, any resultant diversification ratio above 1.15 indicates risk mitigation. The 50/40/10 portfolio built with FTLS earns a 1.17 diversification ratio, a 2-point premium over the 60/40 mix.
The greatest degree of diversification—a 12-point premium—has been derived from the addition of a gold exposure. Energy master limited partnerships, represented by AMLP, trail close behind with an 11-point premium.
Diversification is at the heart of the rationale for alts investing. Diversification is obtained because alternatives tend to behave differently than stocks or bonds. The strength of an alts exposure’s yin to conventional assets’ yang determines the utility of their combination. And all that can be summed up in the diversification ratio. A high ratio, it must be said, doesn’t guarantee a positive return. The unique characteristics of an alternative investment may present their own set of risks—uncorrelated to stocks or bonds. You can see this played out in the year-to-date return of AMLP portfolio.
The bottom line? Consider the diversification ratio of an alternative investment—or any investment for that matter—along with other metrics before making an allocation.
Brad Zigler is WealthManagement's alternative investments editor. Previously, he was the head of marketing, research and education for the Pacific Exchange's (now NYSE Arca) option market and the iShares complex of exchange traded funds.
