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The search for the Holy Grail has always ended in disappointment, except, maybe, for the Knights Templar. But that's another discussion entirely. After this past Bear market, I began searching for a long term hedge, or alternative strategy that would dampen volatility or would at least lose less in a down market. Since I primarily invest and trade over long time frames, I wanted something I could hold a core position in for years if need be. My Holy Grail would have low correlation to the overall equity and bond markets. A diversification across less traditional investment vehicles, so to speak. I scoured the financial sites perusing mutual fund descriptions and performance data. I looked at long/short, market neutral, balanced, and alternative asset/strategy mutual funds. I finally settled on The Merger Fund and Pimco's Commodity Real Return Strategy Fund. Both are mutual funds. I've held them for nearly a year. Recently it was announced that the primary manager of Merger was retiring after 18 years at the helm. My knack for grasping failure from the jaws of victory reared it's ugly wart covered head! I don't trust his replacement, so my position will be liquidated.

Months after my initial investment in the funds mentioned, I became interested in Forex and to a much lesser degree, Options and Futures. I emerged myself in the study of Ichimoku technical analysis and set up several trial accounts with Forex brokers. I dipped my toe in options by studying some basic strategies and purchasing contracts in long term deep in the money calls. I never quite got around to exploring Futures. Furthermore I already had exposure to commodity futures through the Pimco fund. For reasons I will not discuss here (ask me and I will), I found my ideas falling flat. A lack of time was a contributing factor. So my search began anew for mutual funds that gave me exposure to these areas.

What I found was a hodgepodge of performance and strategies. I looked into the Merk family of mutual funds. Merk's specialty is currencies. I crossed them off the list when I looked at performance data. Sure, a blind squirrel finds a nut sometimes. But it looked like they were struggling to find the oak tree. I researched the AQR family of funds, a family run by hedge fund managers who are known for their futures trading. Looked promising, they trade futures on everything from currencies to bonds, equities and commodities using either long or short positions. Buzzkill, $100,000 minimum investment! I came across Natixis funds. A family that used all the strategies I wanted exposure to. However, a lack of manager performance history and the fact they charged a load forced me to disqualify them as a candidate. Oh and by the way expense ratios for all the candidates were pretty high as well.

What I was missing in my research was that I hadn't looked at ETFs at all. Frankly, I didn't think that there were many options that covered what I was looking for, in the ETF universe. Eventually I took a gander anyway. At the very least, I knew that expense ratios would be much lower and the ability to add or trim positions anytime the market was open in a few seconds was also appealing. Surprisingly, what I found intrigued me. I found ETFs that covered everything I was looking for. Below is a list with descriptions from their prospective websites of the ETFs I am considering. Farther down I will discuss my reasoning which will include a daily chart of the ETFs overlayed on the S&P 500 daily chart.

1. ALT - iShares Diversified Alternatives Tust The objective of the Trust is to maximize absolute returns from investments with historically low correlation to traditional asset classes while seeking to control the risks and volatility inherent in futures and forward contracts by taking long and short positions in historically correlated assets. The return on assets in the Trust is not intended to track the performance of any index or other benchmark.
2. MNA - IQ Merger Arbitrage ETF The IQ Merger Arbitrage ETF seeks to track, before fees and expenses, the performance of the IQ Merger Arbitrage Index. The Index seeks to achieve capital appreciation by investing in global companies for which there has been a public announcement of a takeover by an acquirer. This differentiated approach is based on a passive strategy of owning certain announced takeover targets with the goal of generating returns that are representative of global merger arbitrage activity. The Index also includes short exposure to global equities as a partial equity market hedge. Merger arbitrage is a directional hedge fund strategy. The IQ Merger Arbitrage ETF is not a hedge fund and does not invest in hedge funds.
3. ICI - iPath Optimized Currency Carry ETN The Barclays Capital Intelligent Carry Index™ adopts an innovative strategy to enable investors to capture returns from foreign currency markets. The index is designed to reflect the total return of an "Intelligent Carry Strategy," which, through an objective and systematic methodology, seeks to capture the returns that are potentially available from a strategy of investing in high-yielding currencies with the exposure financed by borrowings in low-yielding currencies sometimes referred to as the "carry trade." The pool of currencies to which the index may apply these strategies is commonly referred to as the "G10 currencies" and includes the U.S. dollar, the euro, the Japanese yen, the Canadian dollar, the Swiss franc, the British pound sterling, the Australian dollar, the New Zealand dollar, the Norwegian krone and the Swedish krona.
4. XXV - iPath Inverse S&P 500 VIX Short-Term Futures ETN The S&P 500 VIX Short-Term Futures™ Index Excess Return (“the Index”) is designed to reflect the returns that are potentially available through an unleveraged investment in short-term futures contracts on the CBOE Volatility Index®. Specifically, the Index offers exposure to a daily rolling long position in the first and second month VIX Index futures contracts and reflects the implied volatility of the S&P 500 Index, which provides an indication of the pattern of stock price movement in the US equities market, at various points along the volatility forward curve. The Index rolls its exposure to the underlying futures contracts continuously throughout each month, targeting a constant weighted average maturity for the underlying futures contracts of one month.

Why did I choose these? Let me explain. My theory (which is certainly not unique) is diversifying across historically noncorrelated assets should help dampen volatility or lessen equity losses. It is important that I make the distinction that some of these alternative assets may have greater volatility and a higher beta when compared to the S&P 500. In other words this portfolio I am discussing should be looked at as a single entity, not four separate ETFs. It is their relationship to one another and combined performance characteristics that I am looking for, in theory. I should also mention that this "hedge" portfolio would be 10-20% of my total portfolio. Reasons for picking these particular ETFs and potential drawbacks I will discuss below.

ALT is an actively managed ETF that invests in futures across many different classes, both on the long and short sides. They also have a global perspective. At one time they may be long German bond futures and short the Taiwan stock index futures, as an example. It's about playing trends across asset classes. One potential drawback is performance may suffer in trendless periods. Another is getting whipsawed during a period of drastic trend changes over the short term. In theory, it should juice returns in up and down trends and not exclusively during strong trends in US equities. Furthermore, it gives you international exposure.

MNA is a passively managed ETF and follows a proprietary index composed of companies involved in publicly announced mergers and acquisitions across the globe. Simply explained it's an arbitrage play. The fund is following the time proven method of shorting the acquirers and going long the companies being acquired. Looking at performance figures for both the Merger Fund and the Arbitrage Fund, both mutual funds with lengthy track records and similar investment techniques, it appears that there is a low correlation with day to day market movements over the long term. They also generally do well in bear markets. If there is a lack of mergers occurring they simply build cash. Also considering that MNA's expense ratio is under 1% and mutual funds that specialize in arbitrage, namely the two listed above, have expense ratios north of 2%, it certainly doesn't have as big of a wall to climb to be in profitable territory. Assuming that the index structure isn't flawed, the only drawback I can see is you are guaranteed never to have outsized gains, up 12% in a year would be a blockbuster year. But the flipside is also true, huge losses are unlikely. Over the long term I would expect to see gains in the 5+% territory on a yearly basis if performance is similar to the mutual funds mentioned.

ICI is a currency ETN. Yes it plays in the Forex market, using a proven profitable technique. It uses the carry trade technique. Basically the fund borrows (shorts) currencies from countries with low interest rates and buys (goes long) currencies from countries with high interest rates. The fund profits from the difference between the two rates. It avoids investing in illiquid currencies and sticks to the G10 currencies. Unfortunately it does not pay out these "dividends". It is simply added to the NAV, theoretically. When the note is called years later, you get the NAV not the par value of the note. Also performance will suffer in "perfect storm" events. That is events that cause a flight to the lower yielding currencies that also happen to be safe ones(read major crisis that causes a flight to the dollar and yen, traditionally the strongest, when they are in a period of low interest rates.) The overall technique, however, seems to reduce volatility when compared to equities. The two year chart shows a pretty flat gentle uptrend with extremely low beta when compared to the S&P two year chart. Once again you won't get outsized gains or losses.

XXV is an ETF that shorts short term VIX futures. The VIX is nothing more than a ratio of call to put options on S&P 500 futures. In a previous blog entry I discussed the VIX's uselessness as a market forecaster. Simply it is a picture of current market volatility or lack there of. So why XXV you ask? Well in the nearly twenty years of data I looked at involving the VIX, in every bull market covered by the data the VIX fell below 13 with short term drops below 10. I am defining a bull market in our friend Ryan's terms. That is from the time the 5 month exponential moving average crosses above the 13 month simple moving average until they cross over again, which is a good indicator of the beginning of a bear market. Since the VIX is currently trading in the 18's and has not reached 13 or below since before the last bear market, the idea is to short it until it falls to 13 or lower and then sell XXV and begin going long the VIX, through either VXX or the new CVOL(VIX related etf recently IPO'd by Citi which looks like it may have at least 75% capture of VIX movements, compared to the approximately 50% capture exhibited by VXX.) After a long VIX position is established, the plan would be to stay long until the VIX reaches the mid thirties or higher which according to the data has been reached in every bear market(using Ryan's bear market definition.) After the VIX hits 35+, but certainly not much past 40, sell the long position or set a reasonable stop. Certainly sell on any monster spikes into astronomical areas! After selling the long position stay in cash or deploy it to other areas. Only begin buying XXV after the 5 month ema crosses back above the 13 month sma, which most of the time confirms a bull market has started.

One thing I should mention in reference to MNA and ICI; daily volume on both of these is thin. Daytrading these two ETFs could be hazardous. Since that is not my style nor my overall plan, it is of much less consequence to me. Obviously, to some here it would make a huge difference.

Outside of the conditions I mentioned for buying and selling XXV/VXX/CVOL, I would not trade these ETFs often. My plan would be to rebalance on a monthly or quarterly basis so that I held equal positions in all. The benefit of this strategy is that it forces you to harvest profits and buy the laggard, kind of a Dogs of the Dow strategy except on a shorter time frame.

Since several of these do not have a long track record, I am tracking them on a watch list observing for behavior under different market conditions. With equal amounts invested in each one, the portfolio of these four candidates has performed as I expected it to. Granted I have only been tracking them since the November 12th close. The recent big down day resulted in only a .15% drop in the overall portfolio for the day. I expect the portfolio to continue to perform as I predict until the end of the present bull market. However the real test is how it will perform during the next bear market. I'm predicting that the overall return will be negative during those periods but significantly less negative than the overall market. Of course that is only a prediction and until those market conditions actually occur I cannot confirm if I am correct or not. I will post monthly performance figures in the comments section for the portfolio compared to the S & P 500.