The explosive growth of alternative exchange-traded funds-to more than $146 billion today from approximately $42 billion five years ago-has raised the question of whether they've met the expectations of their investors.

These vehicles-defined as ETFs that seek exposure to commodities and futures markets or that provide a leveraged, short, or hedge fund-like investment strategy-have less than one-fifth the assets of much older and widely accepted long-only equity ETFs. However, the buzz around alternative ETFs is much louder.

To answer whether they're proving themselves as useful as one might think, we've modeled some hypothetical investors (the typical conservative, moderate, and aggressive types) and factored in some of the more widely used alternative ETF strategies to see how they might have changed each investor type's risk and return.

As with any model we had to accept some limitations. First, the history of most "alt" ETFs is pretty short, and testing over brief periods isn't very meaningful (we settled on five years). Second, the differences among products within a particular category can be quite small, so we did not use all of them. Third, we didn't seek to find the "perfect" allocation of these products.

No one could know that ahead of time, so we assumed a 10% allocation. Finally, returns in cash have been nearly zero for a few years; therefore, the risk/reward ratio for cash isn't meaningful, and we excluded it from the basic allocations.

We also assumed that the investors had only mutual funds in their starting portfolio. But we did not want to assume they had only the largest fund in each asset class or that they held the average, which can change over time. Instead, we used the survivorship, bias-free Lipper fund indices as a proxy for each asset class. We also sought to limit the influence of volatile moments in the market by rebalancing the portfolios monthly. We also assumed that each rebalance was a cost-free transaction. We gave each investor a basic, broad exposure to equity, bond, and real estate assets, as shown in Figure 1.

Next, we chose our ETFs. In this exercise we used four very different products to represent four common alternative ETF choices: gold (iShares Gold Trust, IAU), commodities (iPath S&P GSCI Total Return, GSP), inverse (ProShares Short S&P 500, SH), and covered call (iPath CBOE S&P 500 BuyWrite Index, BWV). Significantly, none of these was selected based on market share, volume, cost, or bid/ask spread-normally crucial considerations for investors. Only having a performance history of 60 months or more was our guide.

Looking strictly at total return results (see Figure 2), a few points appear to stand out. First, an aggressive investor came out ahead of the no-alts portfolio when any of these asset classes was added. Adding gold provided the biggest boost to performance, and even an inverse-investment allocation helped this long-equity type. A moderate investor was only somewhat helped by commodities, and the conservative investor was helped by only gold (who wouldn't be, given the past five years?). At this stage, it would seem that alternative ETFs were best left to aggressive investors.

But it's not just about the destination. How we got there is probably at least as important for investors, especially those that may be seeking to dial down potential volatility in their portfolio through the use of alternatives. To see if our various allocations made sense in terms of risk and reward we looked at their Sharpe ratios. In this case, given the near-zero returns in the risk-free rate, we excluded it altogether and hence used a "modified" Sharpe ratio.

In Figure 3 we get a very different picture of how our sample of alternative ETFs worked for our investor types. In all but one case (conservative investors who included commodities in their portfolio) the inclusion of an alternative ETF had a positive impact on risk-adjusted returns. In all cases, gold provided the most return per unit of risk.

Curiously, aggressive investors were better off (in terms of risk-adjusted returns) by including a covered-call strategy (often associated with conservative investors) than by investing in an inverse or commodities strategy, which would seem to hold more appeal to that investor type. Along that same line, the conservative investor was better off in Sharpe terms by including an inverse strategy rather than the covered-call option.

Although tomorrow's market will be different than yesterday's, the surprising volatility that investors faced over the past five years has provided a rich laboratory in which to test asset allocation strategies and ideas. While the fact that alternative ETFs gained over $100 billion in assets during that period might be considered achievement enough, their being able to provide a risk-adjusted benefit to common investor types suggests investors haven't fallen for them on buzz alone.

Jeff Tjornehoj is head of Lipper Americas Research, focusing
on the United States and Canada. He is a regular contributor
to Lipper's Fund Flows and Closed-End Funds reports.