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Affluent Investor | June 23, 2017

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What’s Under the Hood? Managing Liquid Alt ETF Strategies

The ETF universe is rapidly expanding, not only in number of funds and total assets, but also in the proliferation of more sophisticated strategies, many which were previously available only to institutional and other high net worth investors. These “alternative” strategies include hedge fund replication, long/short, managed-futures, real-return, volatility-linked, and others. They offer ETF advantages such as liquidity and transparency, and have come to be known as “liquid alt ETFs”.

Another advantage of liquid alt ETFs is that the costs are generally lower than the typical “2 and 20” fees charged by hedge funds. Additionally, the fees are included in the net asset value and therefore the performance, making comparisons with other ETFs and mutual funds easier.

Liquid alt ETFs and mutual funds have restrictions on leverage and liquidity which prevent them from entirely replicating hedge fund strategies; as a result, performance may be diluted relative to traditional hedge funds. However, their liquidity and transparency offer clear advantages.

Managing a Liquid Alt ETF

Many liquid alt ETFs, while based on relatively sophisticated strategies, employ a passive approach, meaning they are managed to track an index. Similar to other passive ETFs, the portfolio manager monitors the holdings to ensure that the characteristics of the fund are closely aligned with those of the index, either through a replication approach or representative sampling. Trading is done as needed for cash management, due to corporate actions, or to ensure the fund is properly aligned with the index.

Unlike more traditional passive ETFs, however, the implementation of liquid alt ETFs is anything but passive. For example, shorted securities and futures cannot be transferred in-kind; therefore the portfolio manager is responsible for executing trades which would otherwise be completed by in-kind transfer, such as for a rebalance or to facilitate creation/redemption activity.

Trading a Long/Short Strategy

The WeatherStorm Forensic Accounting Long-Short ETF (Fund) is a 130/30 fund, with a target 100% net equity exposure via long and short positions in U.S. equity securities; Vident Investment Advisory, LLC (VIA), acts as sub-advisor to the Fund[1]. The Vident team manages the short positions via a prime brokerage account, monitoring margin requirements and collateral positions on the shorts while maintaining the total net equity position to track the characteristics and performance of the benchmark index.

When creations and redemptions occur, while the AP delivers or receives the long positions via in-kind, unlike in a long-only fund, the value of the shorted securities is transferred as cash and the underlying positions are transacted by Vident.

During quarterly rebalances of the Fund, the short exposure is adjusted through a combination of covering and putting on new shorts, adjusting collateral positions, and ensuring margin requirements are met. This is an addition to implementing the transactions on the long positions as well, to align the total portfolio with the new index.

Tax Consequences

Liquid alt ETFs do not always have the same level of tax efficiency as traditional long-only ETFs. While the shorted securities provide investors with potential return enhancement if they underperform, the current tax-friendly treatment of in-kind transactions is not realized on the shorts, so there may be tax consequences. Additionally, how the ETF is structured can have an impact on an investor’s tax liability. For example, ETFs structured as a partnership must pass-through income, expenses, and capital gains to each shareholder on a pro-rata basis, this is in addition to gains or losses realized when selling shares of the ETF.

Any investment in a liquid alt ETF should be carefully evaluated to ensure that the strategy, as well as the structure and implementation, meets an investor’s needs. The implementation, that is, the management and trading of the underlying portfolio, can impact the performance of the fund. The effectiveness of trading and tax management can help reduce the expected tracking error vs. the benchmark index and can help reduce after tax cost to investors.

 

[1] WeatherStorm Capital, LLC, an affiliate of Vident Investment Advisory, LLC, serves as the index provider for FLAG.

 

Disclosure

*This article is for informational purposes only, and is not an offer or recommendation to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any particular trading strategy. Further, none of the information and material in this article is intended to constitute legal advice, tax advice, investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. Additionally, nothing presented in this article shall be deemed to constitute an offer or a solicitation of an offer to provide advisory services to any person in any jurisdiction where such offer or solicitation would be unlawful or otherwise prohibited. Historical data and analysis should not be taken as an indication or guarantee of any future performance, analysis, forecast or prediction. Investing involves risk. Principal loss is possible.

Carefully consider the Fund’s investment objectives, risk factors, charges and expenses before investing. This and additional information can be found in the Fund’s prospectus, which may be obtained by visiting www.flagetf.com. Read the prospectus carefully before investing.

This material represents an assessment of the market environment at a specific point in time 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.

Investing involves risk, including the possible loss of principal. Because the Fund will be shorting stocks, it will incur expenses relating to those transactions. The use of short sales could increase the exposure of the Fund to the market, increase losses, and increase the volatility of returns.

There is no guarantee that the Fund or the index will achieve its investment objective.

Exchange Traded Concepts, LLC serves as the investment advisor, and Vident Investment Advisory serves as a sub advisor to the fund. The Funds are distributed by SEI Investments Distribution Co., which is not affiliated with Exchange Traded Concepts, LLC or any of its affiliates. WeatherStorm Capital has been licensed for use by Exchange Traded Concepts, LLC. FLAG Funds are not sponsored, endorsed, issued, sold, or promoted by WeatherStorm Capital, nor does this company make any representations regarding the advisability of investing in the FLAG Funds.

 

Originally posted on ETF.com.

Denise Krisko is the President of Vident Investment Advisory, an investment management firm specializing in the management of ETFs and portfolios indexed to custom benchmarks. Prior to co-founding Vident Investment Advisory in 2014, she was the Chief Investment Officer of Index Management Solutions, LLC. Prior to joining IMS, she was a Managing Director and Co-Head of the Equity Index Management and Head of East Coast Equity Index Strategies for Mellon Capital Management. She was also a Managing Director of The Bank of New York and Head of Equity Index Strategies for BNY Investment Advisors and a Director for Deutsche Asset Management. Ms. Krisko attained the Chartered Financial Analyst (“CFA”) designation in 2000. Ms. Krisko graduated with a BS from Pennsylvania State University and obtained her MBA from Villanova University.

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