Liquid-Alternative Investing from an ETF Strategist Perspective. Figure 1 Common Factors Found in Alternative Investing

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1 Liquid-Alternative Investing from an ETF Strategist Perspective Note: an edited version of this paper first appeared in the 9/4/2017 Edition of IRIS Liquid-Alternative Investing from an ETF Strategist Perspective What is Liquid-Alternative ( Liquid-Alt ) investing? Most Liquid-Alt strategies will target high absolute riskadjusted returns where the underlying positions, generally invested in publicly-traded assets and derivatives, have low correlations to primary equity and fixed income market risks. Since many of the strategies seek to neutralize these primary market risks, whether beta for equities or interest rate sensitivity for fixed income, some investors will seek to lever their positions to achieve higher returns, especially in a low yield/interest rate environment like the one we re experiencing today. From a risk-factor perspective, Liquid-Alt investing can be viewed as an expansion of the traditional factorbased universe (i.e. Fama/French factors such as size, value, and quality as well as momentum, yield, and low volatility) to include alternative risk factors as displayed in Figure 1¹. By removing the short constraints and adding the ability to invest outside of traditional equities and fixed income, the Liquid-Alt investor is able to harvest more risk premiums than can be found in traditional asset allocation. Figure 1 Common Factors Found in Alternative Investing 1 A full literature review of alternative risk factors goes beyond the scope of this paper. We suggest you refer to 1) Inside the black box Revealing the alternative beta in hedge fund returns. Romahi, Yazann et al., December 2016, J.P. Morgan Asset Management Investment Insights and 2) Factor Investing Risk Allocation: From Traditional to Alternative Risk Premia Harvesting. Maeso, Jean-Michel and Martellini, Lionel, Summer 2017, The Journal of Alternative Investments.

2 Investing is About Underwriting Risk For all its complexities, Liquid-Alt investing can be reduced to this primary bet: the Liquid-Alt investor is forecasting that the implied volatility priced into a trade is meaningfully different than its anticipated volatility (typically anchored to recent realized volatility). Technically, implied volatility is what can be gleaned out of options pricing tied to a particular asset, but it also conceptually captures the risk premium built into a Liquid- Alt trade². Hence, Liquid-Alt investors determine which assets/trades have attractive premiums relative to the risks posed by those positions. The profitability of such a trade can manifest itself in many forms such as: 1. A factor-based long-short equity portfolio (neutralized for equity risk) where the valuations of the longs narrow versus those of the shorts resulting in positive factor performance. 2. A fixed income credit portfolio (neutralized for interest rate risk) where the option-adjusted spreads narrow versus risk-free assets. 3. A merger arbitrage trade where the valuation of the target company narrows. 4. The carry on one asset will out yield a similar asset with less carry. In each of these cases, the market is pricing in some uncertainty (volatility) that the valuation spreads of a known risk premium won t narrow but, rather widen whether due to a factor underperforming (i.e. in value investing, the inexpensive longs underperform the expensive shorts ); corporate credit risk rising (perhaps due to rising default risk); a merger failure causing the valuations of the acquirer and target to revert back to preannouncement levels; or the real yield differential between a currency with more attractive carry versus one with less attractive carry widens because the former experiences unexpected inflation or political risk. If there was no uncertainty (volatility), then the markets presumably would not price it in via a spread between two assets. For instance, if it was near certain that an announced merger would go through, then the stock prices of the acquirer and the target would reflect the expected post-merger value and there would be little to arbitrage by going long the target and short the acquirer. In effect, the Liquid-Alt investor is providing insurance against the uncertainty priced into a risk asset or a risk-based trade; that the market is pricing in too much uncertainty relative to an expected outcome. We wrote about this concept of investors writing insurance against risk premiums in an ETF.com article published in June 2017.³ At its core, the act of investing amounts to underwriting insurance risk, where the investor earns a premium for their willingness to underwrite downside risk (it s what constitutes the premium in risk premium). ² A good example is applying the Merton options pricing model to risky fixed income (credit risk). Owning risky debt, such as high yield, can be viewed as holding two positions: 1) Risk-free debt and 2) Short position in a put option that allows the stockholders to put the assets of the company back to the debt holders without further liability (in exchange for the debt). If the assets perform well, the put expires worthless, and the debt holder receives the riskless rate plus a credit premium equal to the price of the put that was written. 3 We Are All Insurers Now. Lavine, Benjamin, 6/19/2017, ETF.com.

3 Investors earning risk premiums are willing to take on risks that others are unwilling to bear at a certain price point, although, behaviorally, this tends not to be the case at the extreme price points, whether sky-high valuations for 1999 dot-coms or pennies on the dollar for book values of financials during the depths of the 2008 Great Recession. In the case of investing, we crave for upside participation but want to avoid downside risk; it s one reason why expensive variable annuities are still popular. Yet, over time, investors overestimate equity volatility as reflected by the historical gap between implied volatility and subsequent realized volatility (Figure 2). Part of this gap can be explained by constant demand from investors for downside risk protection in the form of higher premiums embedded in options pricing. For those few periods where realized risk exceeds implied risk, the payoffs for downside protection can be significant but such periods are difficult to predict. Figure 2 Over Most Periods, Price of (Implied) Risk Exceeds Actual Risk

4 Credit for this concept of investing as a way of providing insurance for downside protection goes to the principals at AQR Capital who published, Embracing Downside Risk, in the Winter 2017 issue of the Journal of Alternative Investments.⁴ By deconstructing S&P 500 s return into a covered call component and long call component, they observed that nearly all of the S&P 500 Index s return may be attributed to its covered call component or the insurance premium portion for taking on downside risk. Yet, the long call position contributes little reward while still contributing 41% of the underlying market risk. So, long-term equity investors are essentially writing insurance (covered calls or puts) to asymmetric risk-adverse investors who want upside participation but not the downside. This is what amounts to the equity risk premium (returns above cash) with respect to equity investing that we all hear about. And the asymmetry is key, for if there was no asymmetry in risk appetite (i.e. everyone is risk neutral with respect to gains and losses), then there would be no reward for underwriting insurance risk, nor would there be any for equity risk premiums. It s why underwriting insurance for property/casualty risk is generally profitable. At the micro level, insurance buyers will not likely file a claim over the life of the policy. Nonetheless, property owners take out insurance for the unlikely tail risk because they could not afford to absorb the financial losses in the event of a tail risk outcome. Larger pools of capital (i.e. insurance providers) can afford to take individual losses due to a diversified portfolio (and their ability to earn above their cost of capital). So, this is perfectly rational even if property owners are asymmetric in their risk preferences towards catastrophic losses. But is it rational for investing? Now there may be certain situations where the implied volatility priced into a trade is too low relative to its expected volatility (one could argue that this is systematically true in today s environment across global equities and fixed income markets), so the more adept Liquid-Alt strategists will course correct from selling volatility to buying volatility. In other words, the Liquid-Alt strategist would shift from underwriting insurance (and earning the premiums) to buying protection against downside tail risk (and paying the premiums for that protection). But just as with insurance for protection against property/casualty losses, those long volatility premiums cost money, so returns dwindle each day unless there is an event that allows the Liquid-Alt investor to file a claim. Given the radioactive effects on returns from going long volatility (this is due to the steepness of the VIX term structure that results in negative rollover costs and the fact that options have expirations) and how difficult it is to forecast an event that would cause volatility to spike, most Liquid-Alt investors will find themselves in the role as insurance sellers rather than buyers. Bull markets have laid waste to market-timers⁵ as have those who specialize in going long volatility. 4 Embracing Downside Risk. Israelov, Roni et al, Winter 2017, The Journal of Alternative Investments. 5 Everyone s a Buy and Hold Investor Now. But Can You Stay That Way?, Hulbert, Mark, Hulbert Financial Digest, republished in the Wall Street Journal (8/7/2017).

5 JPHF as an Insurer Underwriting Multiple Lines of Risk Up until recently, investors who build exchange-traded portfolio ( ETP ) models had few attractive and costeffective options for Liquid-Alt investing. Some providers have rolled out various multi-strategy ETPs that seek to synthetically replicate hedge fund performance, but many of their approaches do a poor job because they re built on returns-based regressions between hedge fund returns and potential factors.⁶ Too often such approaches capture more noise than the exposures hedge funds are actually providing. In September 2016, JPMorgan Asset Management launched the JPMorgan Diversified Alternatives Exchange- Traded Fund (JPHF) which seeks to systematically capture much of the alternative risk premiums earned by hedge funds and other alternative investors. Rather than a regression-based approach to synthetically replicate what hedge funds might be doing, JPMorgan s Quantitative Beta Strategies team, led by Dr. Yazann Romahi, uses internal models to build baskets that deliver alternative risk premium covering quantitative long/short equities, global macro, and event-driven risks commonly found in alternative strategies. In other words, JPHF delivers to investors alternative risk premiums built from the security up rather than synthetically replicating those exposures through other asset classes. JPHF also takes on both modest equity and interest rate sensitivity risk. By doing so it complements a traditional asset allocation of equities and fixed income. What JPHF offers is an opportunity to systematically capture much of the alternative risk premiums that can be sourced to alternative investing. For instance, currency specialists will typically incorporate carry or yield, trend or relative performance, and volatility or a preference for low volatile currencies versus highly volatile currencies. Commodity Trading Advisors ( CTAs ) employing managed futures strategies will commonly incorporate trend into their models as well as for the possibility of short-term mean reversion. Capturing carry and trend are two of the strategies implemented in JPHF within the global macro category. So, investors in the fund can feel more confident they re being given exposures to alternative risk premiums, especially with the daily transparency afforded by ETPs. This allows an investor to build a Liquid-Alts program using JPHF as the core allocation. Some other satellite strategies that could be built around JPHF include volatility-based strategies (i.e. tactical long/short volatility, put-write or buy-write option strategies) and creditbased strategies that include or hedge out interest rate sensitivity. So, investors now have more cost-effective opportunities to build a Liquid-Alts portfolio that insures against multiple risks while collecting risk premiums with low correlations to traditional equity and fixed income risk. 6 Maeso, Jean-Michel and Martellini, Lionel, pp 27-28

6 Some Final Thoughts on Liquid-Alt Investing Pay Attention to Price and Leverage Readers of former WSJ journalist-turned-author Roger Lowenstein may remember, When Genius Failed the Rise and Demise of Long-Term Capital. ⁷ The 1997 collapse in Southeast Asian currencies (starting with the Thai Baht) and 1998 collapse of the Russian ruble helped instigate a global-wide risk-unwind tailspin that ultimately forced Long-Term Capital ( LTCM ) to liquidate its leveraged positions at unfavorable prices that almost brought the U.S. banking system to its knees since most of Wall Street had been serving as counterparties to LTCM. What are the main lessons that can be drawn from LTCM s collapse? LTCM s primary problem wasn t its models which largely combined trend and mean reversion, but its size, which was exasperated by tremendous leverage. Its growth also forced the fund to invest in areas outside the firm s core competencies such as merger arbitrage as well as to become less price sensitive in overall allocation (i.e. the money was coming in faster than they could put it to work). An unlevered or modestly levered portfolio can afford to absorb hits from time-to-time (and perhaps wear out the patience of its investors), but such hits shouldn t result in a massive liquidity-driven unwinding of positions. Liquid-Alt investors should always pay attention to price and leverage (as well as the sources financing that leverage, so you don t get a margin call at the worst possible moments). Price is harder to navigate because one can only know if an asset or risk-trade is priced too high or too low after-the-fact, but investors should at least be cognizant of whether they are being properly compensated for the risks taken in the portfolio. Disclosure: At the time of this writing, 3D Asset Management held a position in JPHF. The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate however 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above are all inclusive or complete. Past performance is no guarantee of future results. None of the services offered by 3D Asset Management are insured by the FDIC and the reader is reminded that all investments contain risk. The opinions offered above are as August 10, 2017 and are subject to change as influencing factors change. More detail regarding 3D Asset Management, its products, services, personnel, fees and investment methodologies are available in the firm s Form ADV Part 2 which is available upon request by calling (860) , option 2 or ing sales@3dadvisor.com or visiting 3D s website at 7 When Genius Failed the Rise and Demise of Long-Term Capital. Lowenstein, Roger, 2000, Random House Trade Publications, New York, NY.