In his weekly email, Mike Venuto from Toroso (they're involved with several ETFs including the ETF Industry Exposure & Financial Services ETF (TETF)) looked at the recent performance of many ETFs offering exposure to liquid alternatives (or just alternatives). For anyone new, I've been using alternatives in client portfolios and blogging about them since before the term alternatives was coined, I referred to them as diversifiers.

There are a couple of big problems that I see with alternatives beyond the obvious that some of them just won't work as intended. I think investors develop incorrect expectations about what diversifiers can do and I think that investors often allocate way more to alternatives than is prudent.

Equities are the thing that outperforms all other asset classes and strategies. The tradeoff for equities' performance is volatility that at time can cause investors to panic into financially self-destructive behaviors. Used correctly and in proper sizing, alternatives could help manage that volatility (smooth out the ride a little) without giving away to much upside. Too much in alternatives leads to giving away too much upside.

The following chart captures some of the "alternatives" we have looked at before with the S&P 500 thrown in.

AQRIX is risk parity, PUTW sells put options, MERFX is merger arbitrage, BTAL is long short, QYLD sells covered calls against the NASDAQ 100 and has a very high yield and GLD tracks gold. MERFX, BTAL and GLD are client holdings.

I think this is a useful cross section for looking at expectations as well as potentially challenging environments for certain strategies.

Risk parity looks to evenly allocate risk across asset classes which in a simplified form means leveraging up to own enough fixed income such that the risk taken in that asset class balances out with the risk taken by owning equities. That really is an over simplification but is the building block of the strategy. If rates are going up, and of course they have been, then leveraging up to own fixed income would seem to be a bad idea. An active manager can manage around rising rates but then fund holders are relying on the manager to do it effectively in an environment that markets haven't seen in a while. It may not be worth taking on that sort of execution risk.

I've written several posts saying that buying a putwrite fund now is probably a bad idea. The risk of selling puts at or near an all time high is substantial. As an extreme from the tech wreck, people sold puts on internet stocks that then went on to implode. In December 1999, Amazon (AMZN) was at $106. An investor could have sold a put struck at $80 and probably taken in a healthy premium. Three months later the stock was at $65, by July it was in the mid $40's on its way to $9. Depending on the expiration of the put sold, someone could have paid $80 for a stock trading for half that. Yes, if they held on long enough, they'd have been bailed out but I am not sure too many people would have held on.

Merger arbitrage continues to function as an absolute return vehicle. When the market is up a lot, it lags, when the market struggles it looks good by comparison. It had problems in the financial crisis when parts of the bond market stopped functioning properly. I doubt that will happen again but if it does then merger arb could again struggle. Look at the history of the fund, it clearly will not be out in front of a big rally, but I believe it can help smooth out the ride.

Venuto's commentary talks about long short having done well. This space has come a long way in sophistication with BTAL as exhibit A. When these first popped up as ETFs I was dubious about the first long short funds being anything other than equity proxies but BTAL has proven to me that it is not just an equity proxy. While it is up nicely this year, its short term moves look nothing like the S&P 500. I find that compelling for a diversifier.

QYLD is a very interesting fund and while it might go down a little bit less than the broad market I do not think that investors should expect covered calls to effectively soften the blow of a bear market. That doesn't make the fund a bad hold, its about expectations. A high yield with a little less volatility but still mostly an equity proxy.

I continue to like gold in the context of being a diversifier. GLD's history sets a pretty good expectation. It tends to not look like the stock market the majority of the time. Over the last few years the S&P 500 is up a lot and gold is down. The relatively poor performance creates impatience. If stocks rise for another five years then I would expect gold to be weak for another five years (unless something wacky happens with the dollar).

If you do some reading on how to use alternatives you will find suggestions for very high allocations. Gold is a great example of this. Many pundits (maybe they have something gold-related to sell) will suggest 20% or more to gold, this has never made sense to me. Gold is likely to struggle more often than not. The one stretch where it did well sort of recently was the 2000's when domestic equities were on a bumpy ride to nowhere. A large allocation to that return profile would seem to be imprudent.

I favor 2-3% weightings in various strategies adding up to less than 10% during a bull market. I would add exposure as the market was rolling over, I did this during the crisis, blogged about and will attempt to do so whenever the next bear comes.

Alternatives can be a great help but they have to be understood as individual strategies and sized correctly.

The picture is of Hickman Bridge in Capitol Reef National Park.