Inside ETFs Recap: Building A Resilient Portfolio with Liquid Alternatives

by: , Chief Investment Officer and Managing Director | IndexIQ

It was a banner year for Inside ETFs, one of the ETF industry’s leading conferences, as a record number of attendees gathered to discuss the outlook for the funds in the coming year. The theme, “Changing Times. Solutions Defined.” neatly sums up the current state of the ETF world. The last decade has seen huge changes and a proliferation of products. To be successful now you have to solve a clear problem for investors.

The conference convened in early February, with December’s sharp market decline still on the minds of many of the attendees. That month provided a shot across the bow for investors, a reminder that volatility can resurface when you least expect it. With a few blips here and there, stocks had been generally marching upward since the end of the Financial Crisis. Then, in a few days, that all changed.

With the market now having largely recovered, it’s tempting to shrug that off. But a wiser course would be to take the opportunity to review the holdings in your portfolio while the lessons from this sell-off are still top of mind. Robert Shiller, the originator of the influential Cyclically-Adjusted Price-to-Earnings, or CAPE, ratio, was one voice of caution at the conference, noting that market valuations remain historically high. The CAPE ratio – calculated by dividing share prices (usually the S&P 500) by the average of 10 years of earnings, adjusted for inflation – currently sits at 30, well above its long-term average of 15.

While the ratio is not meant as a trading tool, there was nonetheless agreement that the relatively high valuation should give investors pause, particularly in the context of recent events. That, in turn, gave rise to a lively discussion on how to construct a “resilient portfolio” and, to circle back to the conference theme, the role that ETFs should play in addressing that challenge.

We defined a resilient portfolio as one that allows an investor to successfully navigate through the inevitable downturns in the market. It helps to smooth out returns, while also addressing the known investor tendency to over-react to short-term events. One way to achieve this using an ETF-based strategy is to add liquid alternatives to a portfolio. Properly implemented, these funds can help improve a portfolio’s Sharpe Ratio (return per unit of risk) while lowering volatility as measured by standard deviation.

To demonstrate the “resiliency” that a liquid alternative can potentially bring to a portfolio, the table below compares the returns of IQ Hedge Multi-Tracker ETF (QAI) and IQ Merger Arbitrage ETF (MNA), the two largest liquid alternative ETFs, with the S&P 500 Index during the period of volatility the markets experienced in late 2018:

December 2018

4Q 2018

AUM as of 2/28/2019

MNA (at NAV) -0.28% -0.09% $960 million
QAI (at NAV) 1.63% -4.00% $1,016 million
S&P 500 Index -9.03% -13.50% n/a

Past performance is not indicative of future results. An investment cannot be made in an index.

Stocks weren’t the only asset class that had a tough December. On the fixed income side, credit spreads pushed out in 4Q, and prices for riskier assets fell, including high yield bonds. In this instance, a fund like the IQ S&P High Yield Low Volatility Bond ETF (HYLV) could have helped mitigate the impact of the sell-off. The concept of resiliency applies to international and global investing as well. While December was not so much a currency story for U.S. investors, there are times when currencies drive returns. Managing currency exposure through a 50% hedge, such as the one offered in the IQ 50 Percent Hedged FTSE International ETF (HFXI), can increase resiliency here, too.

Ten years into the recovery from the Financial Crisis, memories are starting to fade. The December sell-off provided a catalyst for investors and their advisors to re-think how their portfolios are positioned, with an eye to lowering volatility and preserving capital. For those who have concerns about the market outlook but want to stay invested, reallocating a portion of a portfolio’s assets to one or more liquid alts strategies “defines” one potential solution.

QAI ETF Standardized Performance (%) as of 1/31/2019

1 Month

YTD

1 Year

3 Year

5 Year

Since Inception (3/25/2009)

QAI (NAV) 2.73 2.73 -2.45 2.51 1.43 2.78
QAI (Price) 2.70 2.70 -2.53 2.53 1.40 2.77

Past performance is not indicative of future results. An investment cannot be made in an index.

MNA ETF Standardized Performance (%) as of 1/31/2019

1 Month

YTD

1 Year

3 Year

5 Year

Since Inception (11/17/2009)

MNA (NAV) 1.83 1.83 2.50 4.88 4.01 3.21
MNA ETF (Price) 1.86 1.86 2.35 4.89 3.96 3.22

Past performance is not indicative of future results. An investment cannot be made in an index.

Click on the fund name for the most current fund page, which includes, the prospectus, investment objectives, performance, risk, and other important information. Returns represent past performance which is no guarantee of future results. Current performance may be lower or higher. Investment return and principal value will fluctuate, and shares, when redeemed, may be worth more or less than their original cost. Visit nylinvestments.com/funds for the most recent month-end performance.

The Financial Crisis of 2007–2008, also known as the global financial crisis, began in 2007 with a crisis in the subprime mortgage market in the United States, and developed into a full-blown international banking crisis with the collapse of the investment bank Lehman Brothers on September 15, 2008.

The Sharpe ratio is a way to examine the performance of an investment by adjusting for its risk. The ratio measures the excess return per unit of deviation, or risk, in an investment asset or a trading strategy.

Standard deviation is a statistical measurement in finance that, when applied to the annual rate of return of an investment, is used as an indicator of the historical volatility of that investment. The greater the standard deviation of a security, the greater the variance between each price and the mean, which shows a larger price range.

The S&P 500® Index is widely regarded as the standard index for measuring large-cap U.S. stock market performance.

About risk:

Past performance is no guarantee of future results, which will vary. All investments are subject to market risk and will fluctuate in value.

QAI: The Fund’s investment performance, because it is a fund of funds, depends on the investment performance of the underlying ETFs in which it invests. There is no guarantee that the Fund itself, or any of the ETFs in the Fund’s portfolio, will perform exactly as its underlying index. The Fund’s underlying ETFs invest in: foreign securities, which are subject to interest rate, currency exchange rate, economic, and political risks. These risks may be greater for emerging markets. Fixed income securities also carry inflation risk, liquidity risk, call risk and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so avoiding losses caused by price volatility by holding them until maturity is not possible. In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Leverage, including borrowing, will cause some of the Fund’s underlying ETFs to be more volatile than if the underlying ETFs had not been leveraged. The Fund may experience a portfolio turnover rate of over 100% that will increase transaction costs and may generate short-term capital gains which are taxable.

MNA: Certain of the proposed takeover transactions in which the Fund invests may be renegotiated, terminated or involve a longer time frame than originally contemplated, which may negatively impact the Fund’s returns. The Fund’s investment strategy may result in high portfolio turnover, which, in turn, may result in increased transaction costs to the Fund and lower total returns. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks. These risks may be greater for emerging markets. Diversification does not eliminate the risk of experiencing investment losses. Stock prices of mid and small capitalization companies generally are more volatile than those of larger companies and also more vulnerable than those of larger capitalization companies to adverse economic developments. The Fund is non-diversified and is susceptible to greater losses if a single portfolio investment declines than would a diversified fund. The ETF should be considered a speculative investment with a high degree of risk, does not represent a complete investment program and is not suitable for all investors. The Fund may experience a portfolio turnover rate of over 100% that will increase transaction costs and may generate short-term capital gains which are taxable.

This material represents an assessment of the market environment as at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.

The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.

This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.

Consider the Funds’ investment objectives, risks, charges and expenses carefully before investing. The prospectus and the statement of additional information include this and other relevant information about the Funds and are available by visiting IQetfs.com or calling (888) 474-7725. Read the prospectus carefully before investing.

New York Life Investments is a service mark and name under which New York Life Investment Management LLC does business. New York Life Investments, an indirect subsidiary of New York Life Insurance Company, located at 51 Madison Avenue, New York, NJ 10010, provides investment advisory products and services. IndexIQ® is an indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC and serves as the advisor to the IndexIQ ETFs. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs. NYLIFE Distributors LLC is a distributor of the ETFs. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC.

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Salvatore J. Bruno

Chief Investment Officer and Managing Director | IndexIQ

Sal is Chief Investment Officer at IndexIQ, where his primary responsibility includes developing and maintaining the firm’s investment strategies. Sal joined IndexIQ in 2007 from Deutsche Asset Management (DeAM) where he held a number of senior positions

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