Low Volatility ETF Can Be Risky

Investors may want to hold off getting into the iShares Diversified Alternatives fund until its managers develop a solid track record.
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NEW YORK (TheStreet) -- Investors worried that the stock market is stuck in a trading range might want to consider alternative and absolute return funds designed to profit in both up and down markets, but the most compelling offering fails on several counts.

Last week I wrote about

managed commodity funds

as a way to play commodities in all markets.

The commodity funds go long and short various futures contracts based on the trend in the market. Other funds employ a similar strategy with respect to other asset classes, but a fund with a unique strategy is

iShares Diversified Alternatives

(ALT) - Get Report

.

ALT searches for relative values in the financial markets that can be broken down into three main categories: yield and futures curve arbitrage, technical momentum/reversal and fundamental relative value.

The first strategy involves going long and short at the same time in a similar contract to profit from a mispricing. The second strategy looks for assets that are outperforming or underperforming historical performance. The third strategy seeks to buy markets that are undervalued and short markets that are overvalued.

ALT uses traditional hedge fund strategies used to profit from relative, rather than absolute, prices. For example, if you believe Germany's stock market is relatively expensive compared to France's stock market, then you can profit from a closing of the valuation gap. If you short Germany and buy France, it doesn't matter if the stock markets go up or down, what matters is the France outperforms Germany. Of course, if the gap persists or widens, you stand to lose money on the trade.

Overall, this is a lower volatility strategy, since by going long and short similar securities much of the market risk is removed. Nevertheless, it is very important to remember events such as Long Term Capital Management in the late 1990s, which imploded when markets behaved differently than their models predicted.

This strategy can backfire if and when

extreme market conditions cause major pricing anomalies

, especially those that managers might consider "impossible." Although ALT is not heavily leveraged like LTCM, this is not a low risk investment.

Currently, ALT is long futures contracts in euro, British and U.S. bonds, plus the Dutch, French, U.S. and German stock markets. The stock market contracts all expire on June 18. It is also long the British stock market, with a contract expiring on Sept. 17.

ALT is currently short Japanese, Canadian and eurodollar bonds, plus the stock markets of Hong Kong, Taiwan, Canada and Australia. These stock market contracts expire on June 18. It is also long the Japanese TOPIX index, with a contract expiring on Sept. 9.

In currencies, the fund is currently long the Australian dollar, British pound, Japanese yen, Norwegian krone and Swedish krona; and short the Canadian dollar, Swiss Franc and euro. All currency contracts are versus the U.S. dollar.

Several of the positions have similar expiration dates, but we don't know what strategy the fund is using of the three. While the fund is transparent in that we can check the holdings every day, only the manager knows why these holdings are chosen.

This fund is managed and as with all active funds, the manager will play an important role in the success or failure of a fund. BlackRock Fund Advisors manages this fund and according to the prospectus, the two managers in charge have limited experience with the strategy employed by this fund. Until these managers develop a solid track record, this is reason enough to hold off investing in the fund.

Since inception last November, ALT has been very stable. Shares fell from the $50 initial price down to $49.25 by March of this year, and shares have since risen to $50.55 as of yesterday's close. Since this is an absolute return strategy, gains come slowly, but thus far the fund appears to have underperformed.

With a 0.95% expense ratio, the fee may end up being too large if the fund can't generate better returns. ALT also has low volume, just over 20,000 shares per day, and since it uses futures contracts, there's some regulatory risk as the CFTC, SEC and Congress debate new financial rules.

Overall, ALT is a good concept, but the managers need to prove their skills, in addition to attracting more volume. I would like to see a track record of years, rather than months, before considering an investment in a fund such as this.

For now, a better choice for investors in search of this type of product is the fund

I discussed last week

, the

Rydex Managed Futures Strategy

(RYMFX) - Get Report

. It doesn't use a purely market neutral strategy and tracks an index instead of using active management, but it does have long and short positions in various commodity and financial futures that have led to less volatile returns.

-- Written by Don Dion in Williamstown, Mass.

At the time of publication, Dion Money Management was not long any of the funds mentioned.

Don Dion is president and founder of

Dion Money Management

, a fee-based investment advisory firm to affluent individuals, families and nonprofit organizations, where he is responsible for setting investment policy, creating custom portfolios and overseeing the performance of client accounts. Founded in 1996 and based in Williamstown, Mass., Dion Money Management manages assets for clients in 49 states and 11 countries. Dion is a licensed attorney in Massachusetts and Maine and has more than 25 years' experience working in the financial markets, having founded and run two publicly traded companies before establishing Dion Money Management.

Dion also is publisher of the Fidelity Independent Adviser family of newsletters, which provides to a broad range of investors his commentary on the financial markets, with a specific emphasis on mutual funds and exchange-traded funds. With more than 100,000 subscribers in the U.S. and 29 other countries, Fidelity Independent Adviser publishes six monthly newsletters and three weekly newsletters. Its flagship publication, Fidelity Independent Adviser, has been published monthly for 11 years and reaches 40,000 subscribers.