WisdomTree

Dynamic Bear, Dynamic Long/Short, Liquid Alternative, Managed Futures

Diversify with Liquid Alternatives

by Christopher Gannatti, Associate Director of Research on March 31, 2016

What makes analyzing alternatives especially challenging is that individual options—even when they are in the same category—can be positioned in very different ways. Furthermore, exposures for any individual strategy can significantly change over time. All this analysis and monitoring can be a daunting task for even the most sophisticated investors.

We believe it is imperative to focus on the goal or portfolio objective to be achieved when considering liquid alternative investments. One result of this analytical framework: A diversified portfolio of liquid alternatives could make more sense than an individual strategy.

Goals of Alternatives

While there are numerous goals for alternative investments, and they are often subject to differences of opinion, we are looking to help people come to a potentially useful analytical framework for analyzing these investments. We see three main types:
 
1) Growth Options: Alternatives in the growth category typically seek to produce attractive total returns from capital appreciation, income generation or some combination of the two. They aim to accomplish this goal by exposing investors to “unique” beta, which in simple terms is a market exposure significantly different from equities, bonds or cash.

• Unique beta with a capital appreciation goal could include such investment strategies as venture capital, buyouts, growth equity, long-biased equity hedge and activist event driven.
• Unique beta with an income goal could include investments such as private lending and strategies that seek to sell volatility, which means that assets sold have the potential to increase in price at times when market volatility is increasing.

 
2) Uncorrelated Options: Alternatives in this category attempt to generate a steady, positive return stream that is uncorrelated with stocks, bonds or cash. The purpose is to introduce to a portfolio a return stream that would not be influenced by the behavior of returns in more traditional asset classes, thereby lending the potential to lower overall portfolio volatility. In technical language, the goal is to have no beta exposure at all.

• Uncorrelated alternatives can be constructed to be market-neutral.
• Uncorrelated alternatives may consist of market timing indicators that vary the asset class exposures over time, meaning that a signal could be utilized with the consequence being either a long position or a short position in a particular asset. Managed futures are one of the more widely known examples in this category.

 
3) Defensive Options: Alternatives in this category attempt to mitigate the risk of major drawdowns in negative market environments. These strategies are generally focused on having higher potential returns during big declines in either the stock or bond market.

• Some strategies designed to achieve this goal are short-biased stock or bond exposures or buying assets that have the potential to increase in value during increased market uncertainty and negative sentiment.

 
WisdomTree’s Alternatives Toolkit

WisdomTree has a broad set of options in alternative investment strategies. Below, we organize them into the three broad categories that we defined above. We believe they can represent interesting complements to existing strategies that might be a bit more illiquid.
 
Growth Options

WisdomTree Dynamic Long/Short U.S. Equity Fund (DYLS): DYLS tracks the returns, before expenses, of the WisdomTree Dynamic Long/Short U.S. Equity Index, which has the potential to be 100% exposed to equities in an unhedged manner.
 
WisdomTree CBOE S&P 500 PutWrite Strategy Fund (PUTW): PUTW tracks the returns of the CBOE S&P 500 PutWrite Index before expenses. It is important to note that the put options being sold in the Fund have the potential to increase in price if volatility is increasing.
 
Uncorrelated Option

WisdomTree Managed Futures Strategy Fund (WDTI): WDTI tracks the returns, before expenses, of the Diversified Trends Indicator™ (DTI®), which tends to have short positions in commodity or financial futures exhibiting declining price trends and long positions in commodity or financial futures exhibiting appreciating price trends.
 
Defensive Option

WisdomTree Dynamic Bearish U.S. Equity Fund (DYB): DYB tracks the returns, before expenses, of the WisdomTree Dynamic Bearish U.S. Equity Index, which has the potential to be, at most, 25% exposed to equities, as it is always at least 75% hedged. On the other hand, it has the potential to be 100% short equities.
 
Three Categories in the Alternatives Toolkit
3 Categories in Alternatives

 
How We Think about Allocating across These Categories

A critical consideration regards whether an investor’s objective is more conservative or more aggressive. For more conservative asset allocation models, we think it could make sense for about half of the exposure to come from strategies that we would consider in the growth category, but tilted more toward income as opposed to capital appreciation. The other half could be split between uncorrelated and defensive categories. Upon moving up the asset allocation model risk spectrum toward the more aggressive end, an investor can add exposure to the growth category in strategies tilted more toward capital appreciation.

Important Risks Related to this Article

Diversification does not eliminate the risk of experiencing investment losses. Using an asset allocation strategy does not assure a profit or protect against loss. Investors should consider their investment time frame, risk tolerance level and investment goals.

DYLS and DYB invest in derivatives, including as a substitute to gain short exposure to equity securities. Derivative investments can be volatile, and these investments may be less liquid than other securities, and more sensitive to the effects of varied economic conditions. Derivatives used by the Funds to offset their exposure to market volatility may not perform as intended. The Funds may engage in “short sale” transactions and will lose value if the security or instrument that is the subject of a short sale increases in value. A Fund that has exposure to one or more sectors may be more vulnerable to any single economic or regulatory development. This may result in greater share price volatility. The composition of the Indexes is heavily dependent on quantitative models and data from one or more third parties, and the Indexes may not perform as intended. The Funds invest in the securities included in, or representative of, their Indexes regardless of their investment merit, and the Funds do not attempt to outperform their Indexes or take defensive positions in declining markets.  

PUTW will invest in derivatives, including S&P 500 Index put options (“SPX puts”). The value of the SPX puts in which the Fund invests is partly based on the volatility used by market participants to price such options (i.e., implied volatility). The options values are partly based on the volatility used by dealers to price such options, so increases in the implied volatility of such options will cause the value of such options to increase, which will result in a corresponding increase in the liabilities of the Fund and a decrease in the Fund’s NAV. Options may be subject to volatile swings in price influenced by changes in the value of the underlying instrument. The potential return to the Fund is limited to the amount of option premiums it receives; however, the Fund can potentially lose up to the entire strike price of each option it sells. 

An investment in WDTI is speculative and involves a substantial degree of risk. One of the risks associated with the Fund is the complexity of the different factors that contribute to the Fund’s performance, as well as its correlation (or noncorrelation) to other asset classes. These factors include use of long and short positions in commodity futures contracts, currency forward contracts, swaps and other derivatives. 

The Fund should not be used as a proxy for taking long-only (or short-only) positions in commodities or currencies. The Fund could lose significant value during periods when long-only indexes rise (or short-only) indexes decline. The Fund’s investment objective is based on historic price trends. There can be no assurance that such trends will be reflected in future market movements. The Fund generally does not make intramonth adjustments and therefore is subject to substantial losses if the market moves against the Fund’s established positions on an intramonth basis. In markets without sustained price trends or markets that quickly reverse or “whipsaw,” the Fund may suffer significant losses. The Fund is actively managed; thus, the ability of the Fund to achieve its objectives will depend on the effectiveness of the portfolio manager. Due to the investment strategy of certain Funds, they may make higher capital gain distributions than other ETFs. 

Please read each Fund’s prospectus for specific details regarding each Fund’s risk profile. 

Alpha Financial Technologies, LLC (“AFT”) owns all rights to the Diversified Trends IndicatorTM and DTI®. The Fund is not sponsored, endorsed, sold or promoted by AFT. Neither AFT nor its affiliates make any warranties or guarantees as to the results to be obtained in connection with the use of the DTI or an investment in the Fund, and AFT and its affiliates shall have no liability in connection with any Fund investment.

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