Whether you’re a mega-sized pension plan or a regular retail investor just starting out, portfolio construction is based on the same basic tenet asset allocation. Cobbling together a portfolio of different asset classes should drive better long-term returns. It’s the basic gist of modern portfolio theory (MPT). Stocks, bonds, real estate, precious metals, etc., all move in different directions and magnitude. This lack of correlation provides strong returns in both up-, down-, and sideways-moving markets.
Increasingly, however, those non-correlated sources of returns are getting harder to come by. This is why many investors now have a real interest in so-called liquid alternatives.
Active ETFs are driving that revolution. From hedge fund tactics to managed futures and sophisticated option strategies, active ETFs have enhanced the alternatives movement. Now, the growth seems unstoppable.
A Word About Correlation & Liquid Alts
When we construct a portfolio, we are thinking about one thing: how all of our assets move during various market scenarios. MPT shows us that by focusing on a variety of different asset classes, we can create a portfolio that generates steady returns no matter what the economy, stock market or geopolitical situation is doing. This is what diversification is all about.
How we measure what zigs when something zags is its correlation. You’re measuring the strength of the relationship between the returns of two investments.
Perfectly correlated investments—often rated as +1—will always increase or decrease in value at the same time and at roughly the same rates. On the flipside, two negatively correlated assets will always move in opposite directions. If you hold a portfolio of 40 different asset classes and their correlations are similar, then it doesn’t matter if you hold a diverse basket of assets.
The problem is that, over time, many asset classes are now becoming more correlated, not just in direction but in magnitude. This chart from Morgan Stanley shows how stocks and bonds have grown in correlation over the last decade or so.
Source: Morgan Stanley
Given that portfolios and many major asset classes are now moving in lock-step and have lost many of their diversification benefits, investors have been drawn to alternatives.
Alternatives can include a wide range of assets and strategies designed to provide returns in a variety of market conditions. This can include somewhat familiar things like real estate, gold, and currency to more exotic fare like managed futures, options strategies, long-short, and event-driven trading. Private credit, private equity, and private real asset investing also fall under the umbrella of alts. The idea is these alternatives provide portfolios with non-correlated exposure and increase the diversification factor. The proof is in the pudding, with numerous studies showing alts can boost returns and reduce risk/drawdowns.
Active ETFs Make Alts Happen
Previously, you needed to be a high-net-worth investor, a pension fund or endowment to get the benefit of alternatives into your portfolio. But like many asset classes, the growth of ETFs has democratized the theme. And active ETFs are making it happen.
Data from investment researcher Cerulli shows how powerful active ETFs have been in making alternatives a reality for investors. Back in 2019, commodities and real estate ETFs made up 65% of what Cerulli defines as alternative category ETFs. The vast bulk of those were passive funds. As of 2024, these two groups now only make up 37% of the category. The market share loss has been filled with new ETFs offering derivative income, defined outcome, managed futures, and cryptocurrency exposure. More importantly, the management style difference has been overwhelming in favor of active over passive.
Data from CFRA research backs this up. More than 40% of new active ETFs listed in the U.S. used derivatives as a main component of their investment mandates. This is up from just 20% in 2014. By the end of last year, derivative-focused ETFs made up 27% of the total number by fund count.
Once again, the ETF structure enhances active management and liquid alternatives benefits.
The nature of the liquid alts asset class/strategy is human centric. Technique and skill vary from manager to manager. As such, it’s hard to replicate in an index. After all, managers want to keep their methods secret. Previously, the Investment Company Act of 1940 required ETFs to disclose their holdings daily. But with semi-transparent and non-transparent ETF structures now available, alts managers can keep their methods secret.
Active ETFs also help reduce costs and fees for investors. Liquid alts funds are often some of the most expensive to own and many come with very high investment minimums. But these days, many brokerage firms will allow you to invest as little as $1 into an ETF. Moreover, the liquid alts ETF category features average fees well below 1%. While high by passive ETF standards, that’s still far below the mutual fund category’s average.
Those cost savings come another way as well: taxes. Many liquid alts funds are structured as partnerships with K-1 statements and feature plenty of capital gains. However, with an ETF, those gains taxes could be passed through to APs via the creation/redemption mechanism. This means active ETFs are a very tax-efficient way for these strategies to be structured. Moreover, many distributions from these funds can be treated as tax-advantaged returns of capital, deferring taxes and reducing cost basis for potentially years.
Then there is liquidity to consider. Liquid alts funds often have long lock-up times, with dictated liquidity events. This can make it difficult for an investor of any size to sell their holdings. With an ETF, you can buy and sell as you please on the secondary market.
When combining these benefits of using an active ETF with the rising correlation/need for diversification, it’s easy to see how alternatives are quickly becoming the fastest growing category within ETF launches.
Active ETFs for Alts Exposure
All in all, the growth of alternatives as a portfolio tool is being met by active ETFs. Cerulli’s research finds many advisors want to increase their allocations to alternative investments. However, they were struggling to do so due to the drawbacks associated with the exposures in more traditional funds. Many of those drawbacks are gone with active ETFs. So it’s no wonder why many analysts predict alternatives will be one of the biggest categories of active ETFs going forward, just behind fixed income.
That’s great news for an investor looking to add exposure to the category. Already, there are some great choices among active alternatives ETFs. Some funds have billions of assets under management.
Alternatives ETFs
These funds are selected based on their ability to tap into liquid alternatives across a variety of strategies. They are sorted by their YTD total return, which ranges from -3.2% to 7.7%. Their expense ratio ranges from 0.35% to 1.38%, with AUM between $150M to $40B. They are currently yielding between 0% and 14.1%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| RLY | SPDR SSgA Multi-Asset Real Return ETF | $486M | 7.7% | 0% | 0.50% | ETF | No |
| QAI | IQ Hedge Multi-Strategy Tracker ETF | $695M | 2.2% | 2.3% | 1.13% | ETF | No |
| JEPI | JPMorgan Equity Premium Income ETF | $40.2B | 2% | 11.5% | 0.35% | ETF | Yes |
| WTMF | WisdomTree Managed Futures Strategy Fund | $185M | 1.6% | 0% | 0.65% | ETF | Yes |
| FTLS | First Trust Long/Short Equity ETF | $1.95B | -0.1% | 1% | 1.38% | ETF | Yes |
| JEPQ | JPMorgan Nasdaq Equity Premium Income ETF | $23.4B | -0.3% | 14.1% | 0.35% | ETF | Yes |
| DBMF | iMGP DBi Managed Futures Strategy ETF | $1.38B | -2.5% | 2.9% | 0.85% | ETF | Yes |
| FMF | First Trust Managed Futures Strategy Fund | $157M | -3.2% | 2.1% | 1.01% | ETF | Yes |
All in all, liquid alternatives are a great tool for investors looking to expand their diversification. The real win is active ETFs enhance their ability to be used by a variety of different investors. ETFs’ structure allows for the best of these alternatives to shine.
The Bottom Line
Diversification is a must for modern portfolios, but it is getting harder to come by. Active ETFs and the rise of alternatives make the job of finding non-correlated assets easy, while the structure enhances the benefits of the strategies.
