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ETFs Add Exposure to Alternatives

NEW YORK -- Asset managers looking for creative new ways to profit during the global recovery have been launching a wave of exchange-traded products that aim to help portfolio managers and sophisticated investors increase their exposure to alternative investments and small-capital stocks.

Last week, Invesco PowerShares, Scottrade and Van Eck Global all launched specialized exchange-traded funds that provide exposure to everything from domestic small-cap companies to Latin American economies.

"The past year has seen significant growth in investor interest in exchange-traded funds," said Andrea Remyn, managing director of Standard & Poor's Equity Research Services.

Many managers say ETFs are ideal vehicles to provide their portfolios with a little extra diversification or to hedge certain asset classes.

Seventy-six percent of asset managers believe the market downturn strengthened the argument for having alternative investments in the retail marketplace, according to a new survey by Cerulli Associates.

"The market crisis has heightened the perceived need for alternative investments, with many advisers looking at these products as diversifiers in their clients' portfolios," Cerulli said. "After a severely budget-constrained year in 2009, asset managers are beginning to shift back into product development mode as purse strings begin to loosen."

"The rapid decline in portfolio values during 2008 and early 2009 underscored the need for improved portfolio construction and more diversification," Cerulli said. "To some extent, asset managers' conviction that alternative investments will play a meaningful role in portfolio construction stems more from a perceived need in the market than actual demand."

Treading Carefully

Asset managers say it takes longer and is more expensive to develop and launch alternative products than traditional products, Cerulli said, because of higher research and development costs, investment management and distribution expenses. But proper research and investment analysis is critical when dealing with alternative investments, experts say.

"Research is an important component in helping individuals and advisors understand and invest in this market," Remyn said.

While still small compared to the overall long-term mutual fund market, alternative mutual funds play an important part of some asset managers' overall strategic initiatives, Cerulli said. Assets in alternative mutual funds enjoyed a 73% increase in assets to $144 billion in 2009, following a 38% decline in 2008, Cerulli said.

There were 863 ETFs in the U.S. as of March 31, with assets totaling approximately $806 billion, according to State Street Global Advisors. Industry ETF assets rose $54.2 billion for the month, or 7.2%.

"Alternative strategies and asset classes make up 17% of the ETF market, representing a small but still significant portion of assets," Cerulli said. "By comparison, alternatives represent only 2% of long-term mutual fund assets."

Asset managers are finding that ETFs provide many advantages over mutual funds, including low expense ratios, intraday trading and easier tax reporting. Mutual funds, hedge funds, institutions and investors of all sizes can use ETFs to add exposure and diversity to key areas or even hedge against certain sectors.

"We believe that small-cap stocks are an excellent way to gain direct exposure to the domestic economy of a country," said Jan van Eck, a principal at Van Eck Global. "These companies operate largely or exclusively in their home markets and are positioned to take advantage of local economic trends such as growing household wealth and increasing consumer spending."

Van Eck said the new Market Vectors Latin America Small-Cap Index ETF gives investors exposure to one of the world's most economically dynamic regions. This ETF seeks to replicate the price and yield performance of the index, before fees and expenses. It includes exposure to Brazil, Mexico, Chile, Peru, Columbia, Argentina and Ecuador.

Other new ETFs launched last week provide exposure to small-cap companies in the U.S.

"We are pleased to introduce a unique suite of small-cap sector portfolios that offer investors access to a vibrant portion of the U.S. equity universe," said Ben Fulton, Invesco PowerShares managing director of global ETFs. "Over the long term, small-cap companies have outperformed large-caps with much of this outperformance occurring during post-recessionary periods. We believe the PowerShares S&P SmallCap Sector Portfolios provide investors with a compelling new way to implement sector-based strategies using the beneficial ETF structure."

Fulton said small companies are often more versatile because they can maneuver and change their business plans easier than larger companies.

"We use ETFs extensively," said Sean Clark, chief investment officer at Clark Capital Management Group. "Five to six years ago, you could not invest in alternatives like you can today. This has really institutionalized the individual investor, but the average investor doesn't know what the heck to do with all these choices."

"There are almost an unlimited number of investment classes" in ETFs, added Tom Anderson, head of ETF strategy and research at State Street Global Advisors, noting that there are 91 different SPDR ETFs.

Their ability to trade throughout the day on an exchange also makes ETFs ideal for volatile commodities, which generally perform poorly over the long term and aren't suited for buy-and-hold investors.

"There is a great deal of interest in precision ETFs that provide very particular exposure," Anderson said, noting that ETFs can be used to add exposure to a space, or as put options to remove exposure.

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