Liquid alternatives, often shortened to just “liquid alts,” is the name given to investments that can be sold at any time and fall outside the traditional categories of stocks, bonds, and cash. Breaking down the two words, “liquid” refers to investment vehicles that provide investors with daily liquidity, primarily those regulated by the Investment Company Act of 1940. Therefore, the vehicle plays an important role, and the range of vehicles calling themselves 40 Act funds includes mutual funds, closed-end funds, and exchange-traded funds (“ETFs”), but our discussion will focus on ETFs.

Defining “alternatives” becomes a little fuzzier, as the line between traditional and alternative is not clearly drawn. If you accept that traditional investments consist of stocks, bonds, and cash, then everything else could carry an alternative asset label. However, the world of alternative investments also encompasses the use of traditional assets in a non-traditional way. More on that later, but think of these as alternative strategies.

It’s probably beneficial at this point to identify a few investments that fail to meet the definitions given here. Hedge funds, private placements, antique automobile collections, and direct investments in real estate are examples of investments that are excluded from the liquid alts category because they do not provide daily liquidity. The SPDR S&P 500 ETF (SPY), the iShares Core U.S. Aggregate Bond ETF (AGG), and probably most of the mutual funds in your 401(k) plan are also excluded from the liquid alts definition because they hold the traditional asset classes of stocks, bonds, and cash.

Now that we’ve eliminated a few broad categories, let’s identify some of the types of investments that are part of the Liquid Alts universe. Non-traditional Liquid Alts assets include commodities, currencies, volatility, master limited partnerships (“MLPs”), and real estate investments trusts (“REITs”). Liquid Alts strategies include non-traditional bonds, managed futures, inverse exposure (bear market strategies), market neutral, long/short, and tactical strategies with the ability to retreat to cash. Other sources may classify some of these alternative assets as alternative strategies and vice versa, but as long as you understand the concept, the classification is not important.

Real estate is becoming less of an alternative asset each year. Direct investments in real estate are probably more traditional than buying stocks, but the long-term nature of real estate investments tends to keep them out of typical portfolios of stocks, bonds, and cash. Packaging real estate into REITs made the asset class more like stocks, and last year real estate was promoted to sector status, making it an integral part of the S&P 500 and further blurring the lines between its traditional and alternative labeling.

Examples of Liquid Alts ETFs:

• Commodity ETFs can directly hold precious metals such as the SPDR Gold Trust (GLD), or be futures-based like the PowerShares DB Commodity Index Tracking ETF (DBC).
• Currency ETFs can directly hold foreign currencies, use currency forwards, or implement multicurrency strategies. Examples include the CurrencyShares Euro Trust (FXE) and the PowerShares DB US Dollar Index Bullish ETF (UUP).
• Volatility ETFs, such as the ProShares Ultra VIX Short-Term Futures ETF (UVXY), typically hold futures contracts on the CBOE Volatility Index (“VIX”).
• MLP ETFs, such as the Alerian MLP ETF (AMLP), directly hold MLPs. However, ETFs holding MLPs incur both federal and state tax liabilities. Therefore, many investors and traders prefer to get MLP exposure via exchange-traded notes (“ETNs”) such as the JPMorgan Alerian MLP Index ETN (AMJ).
• REIT ETFs have become mainstream, and the Vanguard REIT ETF (VNQ) currently has more than $33 billion in assets.
• Non-traditional bond strategy ETFs move away from the usual approach of buying quality bonds for their income and holding them until maturity. Instead, they delve into emerging markets, distressed debt, and other fixed-income segments in search of yield and capital appreciation, often with an active or tactical approach. The Virtus Newfleet Multi-Sector Unconstrained Bond ETF (NFLT) is an example.
• Managed futures ETFs chose their holdings from futures contracts covering commodities, stocks, bonds, or other assets, while managing the contract rolls and varying the underlying segment exposures. The WisdomTree Managed Futures Strategy ETF (WDTI) is an example.
• Inverse exposure and bear market strategy ETFs can passively short an entire index such as the ProShares Short S&P 500 ETF (SH), do it with leveraged exposure such as the ProShares UltraShort S&P 500 ETF (SDS), or take an active approach targeting individual stocks such as the AdvisorShares Ranger Equity Bear ETF (HDGE).
• Market-neutral ETFs typically hold equal long and short positions in an attempt to hedge away market influences and capture the alpha from the long and short picks. The QuantShares U.S. Market Neutral Value ETF (CHEP) is an example.
• Long/short ETFs will vary their percentage exposure to long and short positions in an attempt to mitigate downside market action and capture major trends. The First Trust Tactical High Yield Bond ETF (HYLS) executes a long/short strategy on high-yield bonds, and the ProShares RAFI Long/Short ETF (RALS) targets U.S. stocks.
• Tactical strategy ETFs are not obligated to remain 100% invested. ETFs such as Pacer Trendpilot 750 (PTLC) and WBI Tactical High Income Shares (WBIH) have the ability to retreat to cash during adverse market conditions.

Are smart-beta ETFs liquid alts?

The standard definition of a smart-beta ETF is one that uses non-traditional (non-market-capitalization) weighting and selection approaches. Given the descriptions of liquid alts ETFs given here, someone might be prompted to ask if they are one and the same. The answer is no, they are not the same, although there is some overlap. Many liquid alts ETFs fit the smart-beta ETF definition, but there are hundreds of smart-beta ETFs that are not liquid alts ETFs. Many smart-beta strategies use a factor such as yield, volatility, or momentum to select and weight securities. However, in the end, they are usually holding and providing 100% exposure to the traditional asset classes of stocks and bonds.

Why? What’s the point?

One of the big selling points for liquid alternatives is that they tend to have low correlation to traditional asset classes. As such, they are viewed as portfolio diversifiers that have the potential to provide positive returns that are not dependent on broad stock and bond market gains.

Conclusion

ETFs have worked their way into nearly every corner of the market, including liquid alternatives. The need for daily liquidity and exposure to non-traditional assets and strategies are the basic requirements for liquid alts, and ETFs are uniquely positioned to successfully meet these requirements.