How to Put Alternative ETFs to Work for Clients

Originally published on
US & World News
April 19, 2021
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Financial advisors might be sick of hearing the words "alternative investment."

It is no secret that the stock market is overheated, and clients are seeking inroads to more income. When it comes to low yields in the bond market, investors share Jerry Seinfeld's sentiment, "What's the deal with that?" Meanwhile, advisors know the "let it ride" strategy could be dangerous to their practice. And so begins the search for the holy grail of investing: alternatives.

The definition of "alternative" is ultimately decided by you, as the financial advisor, on your clients' behalf. But in general, alternatives are investment styles and strategies used to complement a stock and bond portfolio allocation.

And as the current market cycle for both of those major asset classes progresses, the pressure to identify investments beyond "regular" stocks and bonds intensifies. Here are some tips for preparing to advise clients on alternative investments, specifically alternative exchange-traded funds.

Be Alert to Pitfalls in Alternative Investments

Enter the product pushers, both big and boutique, that have spent years attempting to separate advisors from the KISS method, which stands for "keep investing solutions simple," including alternative investing solutions. In place of KISS, they have supplied advisors with a wide-ranging set of strategies. Some involve sacrificing liquidity to get some projected benefit. Others offer premium yield or higher potential returns for investing outside the public markets or in some weird corner of the financial universe.

Before you jump in, you need to be trained on these newfangled strategies, which takes time. You must be able to justify these investment decisions to your clients and be sure they are truly a fit for the overall financial plan. After all, there has been no shortage of arbitration cases against advisors who deployed alternative investments that didn't work out.

Consider ETFs, With a Twist

You know ETFs. You use them in portfolios as a replacement for individual stocks. Or maybe you use them as a bond replacement, since so much of the corporate and high-yield bond market is driven through huge ETFs in those categories. You may also use ETFs to get access to a special sector or industry in which your client wants to dabble, whether that's robotics, cloud computing or the cannabis industry.

ETFs have evolved from a small set of low-cost index-tracking securities to more than 2,200 highly diverse options in the U.S. and more than 7,000 worldwide. And although too much focus is devoted to a small number of them, when it comes to finding many varieties of alternative slices to slide into your portfolios, there may be no simpler method than turning to ETFs.

Put Process Over Product When Choosing ETFs

Prioritizing the investment process over the choice of specific ETF products is critical. Some illustrations of this point:

  • Are you looking for more yield but less interest rate sensitivity? There's an ETF for that.
  • Are you looking for returns from relatively undiscovered industries or from very small public companies? There's an ETF for that.
  • Are you trying to invest in something that will counter the risk inherent in your stock or bond portfolio, so that you have a hedge when stocks or bonds go down? There's an ETF for that. In fact, there are lots of them, and more are being developed all the time.

You get the point. Finding the product is not your problem. There are efficient ways to search for the exact investment you want. But how do you develop an ongoing process to maintain an alternative segment of your portfolio?

Separate the Portfolio Into Core and Active Segments

The first segment is the core of the portfolio. The goal of the core portfolio is to give your clients broad access to the market as you define it together. Everything beyond the core is more of an active decision. "Active" does not mean constantly buying and selling. It simply refers to anything outside the cookie-cutter portfolio mix.

Alternative investing could actually be considered anything active. The stock market is in a weird place, and the bond market is in a very weird place. So, at the very least, you should be thinking less about how to fit alternatives into portfolios and more about how much of those portfolios should still be in core investments. In other words, stop thinking of alternatives as a side dish. The more markets evolve, the more alternatives to business as usual start to look like the main course.

Select and Categorize Alternative ETFs

You can separate alternative ETFs into categories before incorporating them into a portfolio. Remember that alternative investing can either be about what you invest in or how you buy and sell investments. Hedge ETFs and tactical ETFs are two major categories outside the traditional core portfolio allocation.

Hedge ETFs

Hedge ETFs play a valuable role in helping you clamp down on major losses from the core portfolio when, for example, the stock or bond market is melting like the Wicked Witch of the West. For stocks, that last occurred in early 2020. For Treasury bonds, it was within the last few months. And those were quite possibly just dress rehearsals for bigger declines in the future. Ironically, when markets are melting down, the biggest advantage of hedge ETFs over some of the private placement alternatives is liquidity.

The hedge ETF universe can be subdivided as follows:

  • Inverse equity (index)
  • Inverse equity (active)
  • Hedged equity
  • Equity arbitrage
  • Inflation hedge
  • Inverse bond
  • Short-term bonds
  • U.S. Treasuries
  • Volatility
  • Currency

Hedging can be as simple as "the opposite of stocks or bonds." However, there are several gradients along the spectrum of "long-only" to "short-only," such as hedged equity and equity arbitrage. You can also choose between shorting via a passive strategy (inverse Nasdaq or Dow) and shorting with an active strategy.

Treasuries and short-term bonds can be hedges if they are thought of as a temporary oasis from the chaos of the equity markets. This is different from having bonds be a dedicated, long-term part of your asset allocation.

Volatility and currency are additional ways to invest in an alternative to the usual suspects that fill many advisors' portfolios. The more alternative tools you are aware of, the more you can go about doing what fiduciaries do: all they can to put the objectives of the client above all else.

Tactical ETFs

The other way to use ETFs for alternative investing is through a tactical investment approach. This is less about what is in the ETFs you choose and more about how you use them.

There are scores of stock and bond market subsegments: sectors, industries, factor tilts, capitalization sizes, domiciles and so on. With algorithmic traders and other new, dominant participants in today's markets, an alternative approach is to rotate more frequently among a limited set of ETFs with which you're familiar. In the past, this was commonly referred to as sector rotation. Higher-turnover strategies using ETFs will naturally have a lower correlation to the broad markets.

The objective of tactical investing is to add return through active management of a segment of a portfolio. The strategy assumes that stock and bond markets are more volatile than in the past and are likely to remain that way, given how markets function in today's digital, global marketplace. Tactical ETFs fall into one of three categories:

Rotation. The focus tends to be on more traditional market segments and less on the quirky, esoteric ones.

Aggressive. This is where you let the sails out and allocate a piece of the portfolio to a group of more volatile segments of the equity market. This is not buy-and-hold investing. You might own these investments for months or even weeks. It's not traditional investing, but it is not day trading, either.

Income. An alternative way to boost income in a market starved for investment cash flow is to tactically invest in ETFs that hold stocks with higher yields.

Using alternative ETFs is not a one-size-fits-all strategy. It takes some up-front work to find out if and how you want to go about it. But taking the time to expand your repertoire may give your practice an edge, rather than putting it in the position of constantly defending a strictly traditional approach.

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