Well more than $5 trillion is invested in ETFs globally1, and the days of them being something novel in institutional portfolios have long since passed. In addition to being a significant source of ETF growth, institutional investors have played a leading role in an increasing alternative investment universe expected to reach $14 trillion by 2023.2 Ask those same investors if they’d like increased liquidity, and the answer will very likely be “Yes, please. And may I have some transparency with that, too?”
It’s a bit intriguing, then, that most institutional investors surveyed in an upcoming Greenwich Associates report have not more seriously considered investing in liquid alternative ETFs. These exposures, which check the ease-of-use, diversification, and liquidity boxes that investors love about ETFs. According to the same report, however, there appears to be the beginnings of a movement toward greater adoption of liquid alt ETFs as a result of compelling use cases that deliver real value to institutional investors. (In an upcoming interview with Kelly Ye, Director of Research at IndexIQ, II will explore several such use cases.)
Comfortable in the liquid alt space
With the exception of corporate pension plans, all other institution types have nearly 25% of their portfolio directed toward alternative assets, and 2% – 6% invested in liquid alts. Among liquid alts, hedge funds and real estate are the most popular vehicles. The trend toward liquid alts has been evolving for some time, with 71% of institutions in the Greenwich survey indicating they began allocating to liquid alternatives more than five years ago.
This comfort level with liquid alts magnifies the oddity that so many institutional investors have never even seriously considered liquid alt ETFs. It has been nearly 10 years since the launch of the first liquid alt ETF, the IQ Hedge Multi-Strategy ETF (QAI) – certainly long enough to overcome fears that they haven’t been around long enough to have a sufficient track record. (And speaking of that track record, it’s interesting to note that since QAI launched on March 25, 2009, the maximum drawdown for it has been -7.88%, compared to -36.13% for the S&P 500 and -10.05% for the HFRI Fund of Funds Composite Index – all during several instances of severe market turmoil3.)
It is noteworthy that hedge funds are the preferred source of liquid alts, according to the Greenwich survey, while at the same time only 45% on investors in the survey said they were at least somewhat aware of the hedge fund replication strategies available in liquid alt ETFs. “Hedge fund” ETFs identify the key characteristics that drive hedge fund performance and “replicate” them in a low-cost, index-based fund. The structure of such ETFs is based on the idea (supported by significant amounts of research) that systematic exposures to traditional and non-traditional asset classes is the broadest source of hedge fund returns – and it’s the returns generated in that fashion that most replication strategies seek to capture with a high degree of liquidity, transparency, and not insignificantly, cost-efficiency.
The whiff of opportunity
History, as they say, is in the past, and while many investors have never considered liquid alt ETFs, that state of play seems poised for change. The Greenwich survey indicates that 8% of institutional investors are currently using liquid alt ETFs or have in the past, dedicating up to 3% of their overall allocations to the category. However, among the large cohort not currently using liquid alt ETFs, nearly 20% have indicated they will consider using them in the next year. Overall, 10% of investors intend to increase allocations to liquid alt ETFs in the next year, and among those already invested in the category, none indicated they planned to reduce their allocation.
As some of the old perceptions of liquid alt ETFs – they’re too complex, they’re too expensive, we don’t know enough about them – begin to fade away, investors are starting to recognize that there is more to them than liquidity, diversification, and transparency. A new appreciation of the versatility and utility of liquid alt ETFs is starting to emerge. For example, at any given moment some portion of an alternative portfolio is likely in transition. Historically, investors have leaned toward keeping these assets as cash or investing them in money market funds. However, more and more investors are realizing that liquid alt ETFs might be a better alternative that keeps them essentially aligned with their evolving alternative investment goals while they perform their due diligence. In other words, liquid alt ETFs provide easy and inexpensive access to desired exposure during periods of change.
Another area where investors see great promise for liquid alt ETFs is as a replacement for some of their allocations currently directed to a fund-of-funds. Investors are attracted by fund-of-funds as they often give them access to managers they might otherwise find unavailable and they can ease some of the back-office load. However, nearly one in five investors in the Greenwich survey say they are at least somewhat likely to replace a portion of their fund-of-funds allocations with liquid alt ETFs. In all likelihood, this reconsideration of fund-of-funds allocation comes down to the fact the liquid alt ETFs are less expensive and more transparent.
Liquid alt ETFs have been a liquid and transparent source of diversification since their inception. It seems that they’ve reached an awareness tipping point, however, and that investors are starting to see them in a whole new and useful light.
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1 ETFGI is a leading independent ETF research firm which offers consulting and analytics services for a range of clients, including investors, product issuers, stock exchanges, brokers, trade associations and regulators.
2 Prequin is an industry leading provider of alternative data and research.
3 The maximum drawdown analysis measures the largest decline between any two points in the daily return history of the respective indexes and indicates the time period during which such drawdown occurred, as well as the date on which the index's returns had fully recovered (if applicable) all losses incurred during the drawdown period.
S&P 500 Index
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The S&P 500® Index is an unmanaged index and is widely regarded as the standard for measuring large-cap U.S. stock-market performance. Index results assume the reinvestment of all capital gain and dividend distributions. An investment cannot be made directly into an index.
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