By Jerilyn Klein Bier

Inflows to alternative exchange-traded funds slowed to $11.6 billion in 2011, their lowest level since 2006, according to the annual Alternative Investment Survey of U.S. Institutions and Financial Advisors conducted by Morningstar and Barron's and released in late May. But the reasons for investing in alternative ETFs remain compelling.

Morningstar ETF analyst Timothy Strauts says investors haven't poured as much money into them because they haven't had great performance recently. But investors might be overlooking their real attraction. "Alternative ETFs are not about outperformance," he says. "The allure is low volatility with more consistent returns."

Strauts says the annual return goal for several alternative ETF categories-including long/short equity, managed futures and multialternative, a combination of multiple asset classes-is in the 6% to 8% range. With market-neutral ETFs, which take matching long and short positions, the hope is for consistent 4% to 6% annual returns, he says.

Alternative ETFs sport several advantages over hedge funds and private equity funds, Strauts says, citing the ETFs' lower fees, greater liquidity and better transparency. ETF fees run from 51 to 95 basis points, versus the typical 2% plus a 20% incentive for hedge funds. And they compare favorably to alternative mutual funds, which typically carry fees in the 1.5% to 2.2%  range. ETF fees tend to be smaller because more than 90% of alternative ETFs are passively managed.

ETFs can be a good way to invest in the alternative bucket if you do your homework, concurred several speakers at Financial Research Associates' recent Advisor and Broker-Dealer's Forum on Retail Alternative Investments.

Douglas Wolfe, head of portfolio management and trading at Saddle River Capital Management LLC in Saddle River, N.J., said his firm usually uses commodity and real estate ETFs for 10% to 20% of its allocation to alternative investments in its portfolios. "It's a little easier to track them and understand what's under the hood," he said.

Wolfe added that other than fixed income, the commodities asset class is the most uncorrelated to equities, and that commodities and real estate also serve as inflation hedges and are easier to explain to clients than other alternative investments.

Wolfe said he prefers broadly-allocated commodity ETFs including the PowerShares DB Commodity Index Tracking Fund (DBC), United States Commodity Index Fund (USCI) and GreenHaven Continuous Commodity Index Fund (GCC). About half of DBC's holdings are in oil or oil-related commodities; the latter two funds equal-weight commodities across their portfolio holdings.

In real estate, his firm alternates between the Vanguard REIT ETF (VNQ) and iShares Cohen & Steers Realty Majors ETF (ICF), which he says pretty much hold the same underlying securities but in different percentages. "They're structured with 50 to 150 holdings so there's instant diversification," he says.

Richard Block, executive vice president of trading at Boston-based QuantShares, a family of seven passively-managed market-neutral and sector-neutral ETFs, said alternative ETFs can generate a return stream that helps diversify a traditional 60/40 stock and bond allocation. He said they also can offer uncorrelated returns to the overall broad market and decrease overall portfolio risk.

When it comes to doing due diligence on ETFs, Block said advisors need to look at whether the fund is doing what it's marketed to do, whether it's leveraged, and if it's unique in the sense it provides access to a strategy you can't deploy yourself. Other points to consider include whether it's actively or passively managed, and if the underlying securities are liquid.

"The liquidity of the underlying securities is the most important thing in determining the liquidity of the ETF, not the ETF's trading volume," Block said. That's because if the underlying securities are liquid, then whoever is trading them can easily hedge exposure.

Understanding tax consequences is also critical with alternative ETFs. "It depends on the asset class and it depends on the structure," said Christian Magoon, CEO of Magoon Capital in Lisle, Ill. For example, master limited partnerships packaged in an ETF or a '40 Act product that's structured as a C Corporation face double taxation-a factor which should be disclosed with clients. SPDR Gold Shares (GLD), the world's largest physically-backed gold ETF, is subject to a collectibles tax rate (28%) instead of capital gains.   

Strauts from Morningstar also stresses the need for education, especially since each alternative ETF follows a different strategy. "Don't be seduced by back tests," he warns, noting that the purported strong performance might not be replicable in the real world.

For example, ETFs are required to report their holdings daily, making them more transparent than hedge funds. That's seen as a good thing, but on the flip side it gives sharp traders a chance to gauge a fund's trading strategy and perhaps buy or sell positions before the fund is able to.

"Normally we like transparency," Strauts says, "but for some [ETFs] transparency eliminates the ability for them to work."