Navigating Absolute Return ETFs

NEW YORK (TheStreet) -- Recently a former colleague asked for help trying to sort through the potentially overwhelming number of choices available among exchange-traded funds that target alternative strategies like absolute return and other hedge fund-like strategies. A look at the IndexUniverse ETF finder shows 30 exchange-traded products in the absolute return category of the alternatives asset class excluding leveraged products.

The Global X Top Guru Holdings ( GURU) is listed as one of the absolute return choices, but Global X views the fund as a core equity holding. There are still enough choices in the category to make choosing one difficult.

The dominant fund in the alternatives sector is the IndexIQ Hedge Multi Strategy Tracker ( QAI), which has $450 million in assets. It blends together several hedge fund strategies including long/short and global macro by using ETFs from various asset classes. The results have been mostly as advertised, inching up slowly with a chart that rarely resembles the stock market. Again that is the point here, slow and steady returns that don't resemble the results of equities.

One popular category judging by the number of funds is merger arbitrage, but the funds have different methodologies and the result can be dramatically different. True to merger arbitrage, the Credit Suisse Merger Arbitrage Liquid ETN ( CSMA) goes long the target company and sells the acquirer short subject to certain strategic constraints. The risk to the fund is if an announced deal fails to materialize.

The ProShares Merger ETF ( MRGR), on the other hand, will sell short the acquirer only in a stock deal. In a cash takeover, it will go long the target but will not have a corresponding short position. The most recent fact sheet discloses the long exposure at 107%, the short exposure at 22% and 15% in cash. That makes the fund much more vulnerable to the ups and downs of the stock market. At times that will help performance and at other times hurt it.

Year to date, MRGR is down 6% versus a gain of 6% for CSMA. Their fates could easily be reversed, but in terms of a product that reduces stock market exposure, CSMA would be the better choice, but of course it is an exchange-traded note, which is an unsecured debt obligation of the issuing bank.

Managed futures is another popular sector. The largest fund here is the WisdomTree Managed Futures Strategy ( WDTI), which has $142 million in assets. The objective with funds in this sector is to go long commodity and financial futures that are above their 10-month moving average and short commodity and financial futures that are below their 10-month moving average with a monthly resetting of the long and short exposure.

Not all the funds use financial futures and the particular moving average can vary, but the big idea is long positive momentum and short negative momentum. This strategy's history is that it usually does well but always and at times it has been more volatile than some of the other strategies mentioned but it definitely succeeds in delivering a result that does not look like the equity market.

Although one article cannot cover the entire absolute return sector, one other fund to mention is the PowerShares DB G-10 Currency Harvest ETF ( DBV), which has $218 million in assets. The fund captures the carry trade by going long the three highest yielding G-10 currencies with 2-1 leverage and sells short the three lowest yielding G-10 currencies with no leverage. This strategy seems to work most of the time, but DBV endured a 36% decline during the financial crisis. That was an extreme event, but in the face of the unknown, back then, the carry trade unwound viscously which means in future market panics, it could happen again.

There is no way to choose the best alternative strategy because there can be no single best strategy. Investors interested in alternative exposure will be best served by learning the differences between the various absolute return segments, choosing the segment that makes the most sense to them, and then studying the differences between the funds in the sector before investing.

The potential benefit to a portfolio is to reduce volatility, but these funds won't keep up with regular stock market exposure over the long term. Alternatives are a hedge to an equity portfolio, too much in the hedge and the long-term benefit of owning stocks is forgone.

At the time of publication the author held no positions in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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