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5 Use Cases for Liquid Alt ETFs

Utility and flexibility are big reasons why institutions are increasingly including liquid alternative ETFs in their portfolios

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New York Life Investments

New York Life Investments

A new Greenwich Associates report reveals an emerging trend toward greater adoption of liquid alternative ETFs by institutional investors. In the same study, investors reveal they have historically been somewhat hesitant in their implementation of liquid alt ETFs, but that uncertainty is giving way as investors begin to appreciate specific use cases for liquid alt ETFs, such as transition management situations and as a portfolio substitute for alternative allocations with significantly higher fees.

To expand upon some of the use cases for liquid alt ETFs, Institutional Investor connected with Kelly Ye, Director of Research at IndexIQ. In the following conversation, Ye outlines five scenarios in which liquid alt ETFs – and their acknowledged ease-of-use, cost efficiency, diversification traits, and liquidity – merit serious consideration from institutional investors.

Use Case #1: Core Allocation

II: In the Greenwich report, some investors say they see a use for liquid alt ETFs as part of their core allocation strategy. Is that a strong use for them?

Ye: Yes, for two reasons. First, many sophisticated investment plans already include an alternatives allocation. Liquid alts offer a more cost-efficient method of making that allocation and access the same risk/return profile as hedge funds. In other words, a large part of the hedge fund return is driven by factors which we label “hedge fund beta.” Research has been demonstrating that for 20 years. Liquid alt products are designed to capture that beta, using public market formats. So, in a way, liquid alt ETFs are an alternative to an alternative – hedge funds offer limited transparency, greater dispersion of returns, and they are expensive. Liquid alts can serve as a more tax-efficient way of making core hedge fund-type allocations.

You mentioned two use cases – what’s the second?

Ye: Given increased volatility we experienced in the market, many investors want to shift part of their core equity or fixed income allocations into alternatives for diversification purposes. For example, MNA1, one of our popular ETFs, works as a bond surrogate. Clients who are bearish on bonds, and view them as too expensive, might like its bond-like features. Others shift equity allocations to MNA, to reduce stock exposure.

Use Case #2: Fund of Funds Replacement

Why might investors want to consider replacing fund of funds’ allocations with liquid alt ETFs?

Ye: A fund of funds is essentially an Outsourced CIO function for investors who lack sufficient alternatives due diligence capabilities to access alternative investments. But there are downsides. The fund of funds usually charges additional fee, which may not be justified by their returns. There is also limited transparency and access to the underlying managers, and limited liquidity to boot. As a solution, some clients turn to QAI2, one of our largest hedge fund replication products. It delivers similar risk and return profiles, offers better transparency reported on a daily basis, and at a much lower cost point.

Use Case #3: Transition Management

Institutional investors regularly review and replace managers, and move in and out of various investments. How can liquid alt ETFs benefit investors during these periods?

Ye: Manager selection can be a very time-consuming process – sometimes it can take a few years because good managers are really hard to find, and the operational burden to onboard a new manager when you find one isn’t something asset owners look forward to. We do often see clients rotating from one manager to another, or bringing up their current alternatives to a full allocation. They may be looking for beta or exposure to that type of strategy, while seeking enough liquidity to get in and out quickly during the replacement or reallocation period. For instance, a client decided to rotate out of their current hedge fund and allocate to QAI for tax loss harvesting while looking to potentially change manager.

Tell us a little more about the tax benefit for ETFs?

Ye: Our MNA ETF, for example, has only paid one capital gain distribution over 10 years, thanks to tax benefits associated with the ETF structure. Likewise, our QAI ETF has never paid a capital gain charge. Other hedge fund structures may not be able to produce that tax alpha, which ranks in importance with liquidity and cost.

So, investors might use our QAI ETF for the tax loss harvesting and also to obtain beta in a cheaper and more liquid format as part of a temporary transition management tool, but that sometimes evolves into a permanent core allocation as the managers recognize the benefits of liquid alts.

Does that happen frequently?

Ye: We’re seeing it more and more as the industry as a whole becomes more familiar with ETF structures, and the concept of liquid alternatives as an asset class. The bottom line is that hedge fund-like returns can be attributed to risk factors that can be delivered through liquid public instruments.

Use Case #4: Enhanced Cash Utilization and Equitization

Suppose an investor wants to allocate cash in a form that tracks as benchmark?

Ye: They would pursue that type of cash equitization to either attempt to achieve similar beta to the benchmark they are tracking, or the cash-plus type of return profile usually associated with hedge funds. Liquid alts are a good alternative to holding cash in both cases because of the underlying liquidity.

But in these cases, liquid alt ETFs aren’t functioning as a cash equivalent, right?

Ye: That’s correct. There is obviously risk when it comes to cash equitization, it’s just a different type of risk that’s usually uncorrelated with the markets. There are three questions investors should answer in this use case: Should they be concerned about return drag? Second, what’s the cash used for? Is it being parked while they look for the next manager, such as in transition management, for example? Third, what’s the investment horizon? It’s easier to park short-term cash if return drag is not a consideration; longer term, it could be better to deploy that cash in liquid alt ETFs, so as to make up some of the return drag.

Use Case #5: Liquidity Management

When you talk about liquidity management and the role liquid alt ETFs can play, are you focused on the alternatives sleeve of an investor’s portfolio, or the holistic portfolio?

Ye: Investors do have concerns about liquidity beyond their alternative investments, so you can look at liquid alt ETFs as a provider of liquidity and diversification to the entire portfolio. Within the alts sleeve there are often additional liquidity worries. Hedge funds, for example, have lower liquidity than liquid alt ETFs, and for more operational burden. Today’s investors want to be flexible and nimble, and if they want to quickly shift their allocations or strategies liquid alt ETFs present them that opportunity. In addition, many institutional investors are obliged to hold greater liquidity than many typical alternative allocations can provide. In those cases, liquid alt ETFs can deliver the best of both words by offering the risk return profile they seek, along with needed liquidity.

Read the full report Greenwich Associates’ report, Liquid Alternative ETFs: The Next Frontier in Institutional Investing.

1. IQ Merger Arbitrage ETF (MNA)

2. IQ Hedge Multi-Strategy Tracker ETF (QAI)

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