Why advisors must do their homework on alternative ETFs

Why advisors must do their homework on alternative ETFs

Why advisors must do their homework on alternative ETFs

The updates to regulations 81-102 opened the door for a myriad of alternative products to hit the market. However, while an effective diversifier, investors and advisors must understand what they’re getting.  When it comes to alternative ETFs, for example, they are not like those in other asset classes.

National Bank Investments was one of the producers who introduced an alternative to the market in January. Part of their first suite of ETFs was NALT, an alternative fund that aims to provide non-correlated returns with lower volatility. For Terry Dimock, head portfolio manager, National Bank Investments, the key with any alternative is that understanding aspect.

“When you are looking at alternatives you are looking at diversification,” he said. “It is an asset class that is uncorrelated, can lower your risk and protect capital in difficult markets. I think understanding what role that alternative ETF plays in your portfolio is important. You need to make sure you understand the behaviour and how it will perform in both up and down markets.” 

Dimock said that he wasn’t surprised to see the plethora of products hit the market since many producers already had strategies they were using on the institutional side. Once the rules changed, adapting the strategy for retail investors wasn’t difficult. 

The strategies within alternative ETFs are an area that Dimock says investors and advisors need to pay attention to. It is what sets the products apart from one another, even within their own asset class. “There are a myriad of strategies you can employ. It is more of a question of what kind of expected behaviours will you get form the strategy itself. As well as what type of underlying assets are used to construct the strategy and the role it plays in the portfolio.” 

Pierre Laroche, a strategist at National Bank Investments, explained to WP that many common hedge fund strategies can be employed in alternative ETFs, such as: long/short equities, market neutral and global macro. “When you look at global macro strategies, this is where the philosophy may distinguish one product from another. Most players position themselves as having good global macro managers who can forecast the market. Then, they sell and explain the merits of their strategy. There are different approaches they can take as well including: discretionary, more quantitative, exclusively quantitative, and exclusively discretionary. The approaches can also be linked to activities on their institutional desks.”  

With the variety of strategies and approaches, bringing alternatives to an ETF format allows advisors to find the proper strategy to answer the portfolio construction needs of their clients. “Alternative ETFs provide simplicity and diversification at a lower cost, which is at that heart of what advisors are trying to help their clients with by providing advice,” added Dimock. 

“Typical Canadian investors will be heavy on equities, say roughly 60% equities, 40% in fixed income. Finding an asset class that is not correlated to both stocks and bonds is a challenge,” added Laroche. “Most advisors have a basket of stocks they can manage properly but when it comes to say commodities, it falls outside of their comfort zone. This is where they need help from professional asset managers to package a portfolio, with a sound investment strategy, that would expose the portfolio to non-equity strategies. Alternative ETFs give access to an asset class they may not be as knowledgeable about.” 

Both Dimock and Laroche outline potential risks with alternative ETFs. For Laroche, he said it comes down to the underlying strategy which could rely on positions of less liquid assets. Dimock pointed to potential dissatisfaction with returns on alternatives, in bull markets. For both risks, understanding the product and the role it is intended to play in a portfolio remains the most important aspect.  

“Advisors need to do their homework. Finding the right allocation (to alternatives) is really the heart of their job. You have to understand the whole view of the portfolio and the needs of every client. You need to understand the role of the alternative, its behaviours and mechanisms. When you do, it will help you build a better portfolio,” said Dimock.  

Dimock believes more alternative products will come to market and is optimistic that once people get familiar with the funds, and their behaviours, their popularity will grow. “I think it can be a part of a well-diversified portfolio. I think equities and traditional fixed income will remain the most important parts but we’ll see alternatives grow. I think they are here to stay. I don’t think you can lump them into one alternative category, they can be quite different. Homework has to go into really understanding alternatives and how it fits into portfolio construction.”