Alternatives Adding Value
The first half of course drew to an end on Friday with the second quarter coming on a little stronger than the first quarter. Anyone who has been reading this site for a while is probably familiar with my belief in moderate use of liquid alternatives (I used to call them diversifiers before liquid alts became widely used). I believe that when used in moderation they can help manage portfolio volatility and correlation. Some diversifiers can be useful for offsetting bear market declines (my primary interest) and there will be occasions where a given alternative might outperform during a period where equities are not down a lot. And if you've been reading this site you might know that for years I have owned the Merger Fund (MERFX) for most clients in the above context.
The following chart compares MERFX to the S&P 500 and the IndexIQ Merger Arbitrage ETF (MNA) year to date;
It shows MERFX up 5.5%, the S&P 500 up 0.8% and MNA down 1.5%. For whatever reason the SPX number is wrong. On a price basis it looks like it was up 1.68%, plus another 90 basis points for dividends, still almost 300 basis points behind MERFX. The vast majority of the time, MERFX lags behind the S&P 500, specifically very frequently during bull markets. It is not an equity market proxy and I don't own it to be an equity market proxy. The chart captures part of why I own it, it is far less volatile than the S&P 500, even MNA, the lag notwithstanding is obviously far less volatile.
Where I regularly say that no strategy can always be the best, no reasonable strategy can always be the worst and no reasonable strategy will always lag even if not the worst. In a period of flat equity markets, having a diversifier add positive attribution with less volatility is a great outcome even if it was just lucky but of course luck plays a role in all of this.
I would also take a minute to touch on MNA's lag. A little over seven years ago I compared MNA to the Credit Suisse Merger Arb Liquid Index ETN (CSMA) which stopped trading a couple of years ago. I noted MNA's lag to CSMA and attributed it to "the fact that it does not short the acquirer it instead shorts broad indexes (either ETFs or futures contracts) in the belief it can capture the effect." There may have been a tweak to MNA's strategy along the way because when I look now it is short Sector SPDRs, iShares MSCI Japan (EWJ) and an ETF that broadly tracks Europe. I don't doubt IndexIQ's veracity in believing that it doesn't need to short individual stocks but I disagree with the conclusion which is why I chose MERFX, true to merger arbitrage it sells short individual stocks.
In choosing to use diversifiers it is crucial to understand the nuance and exact implementation of the strategy being offered. To me, not shorting individual stocks in merger arbitrage is a major detail. The other day I wrote about a proposed Black Swan ETF. What do you think of when you read the name Black Swan ETF? I might think something that goes up when the market goes down (regardless of what might cause it to go down). Well the Black Swan ETF as it stands now will own calls not puts. The fund will not go up when the market goes down a lot, as proposed it isn't really targeting that outcome but by the name you might think it is some sort of inverse exposure. If I ever make my way back managed futures, there are many applications of that strategy. Some versions include equity futures. Where the goal is to reduce correlation along with reducing volatility, long equities is probably not a great way to reduce equity market correlation.