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Here’s What Hedge Funds Should Really Be Worried About

Allocators are increasing their exposure to alternatives — but instead of making direct investments, they’re opting for cheaper ETFs.

Staring down a ten-year-old bull market, institutional investors are increasing their allocations to alternatives to help steady their portfolios. But instead of investing in hedge funds, private equity, and other private market assets, they’re buying lower-cost exchange-traded funds that seek to provide similar returns through rules-based strategies, new research shows.

Institutional assets in liquid alternative ETFs will increase two and half times, from $47 billion to $114 billion, over the next 12 months, according to research from Greenwich Associates released Monday. Liquid alternatives provide investors with systematic exposure to hedge fund strategies, private equity, real estate, and other private investments.

The study, commissioned by IndexIQ — the ETF platform of New York Life Investment Management — and conducted independently by Greenwich, was based on telephone interviews with 107 fund professionals at U.S. institutions. Public pension funds constituted the largest segment of institutions surveyed, accounting for 37 percent of respondents, followed by corporate pensions at 26 percent.

“ETF structures offer institutions the ability to get in and out of positions in real time, and see underlying holdings every day, all at a much lower fee,” said Kelly Ye, director of research and alternative investments at IndexIQ. “Research has shown that a large part of hedge fund returns can be attributed to alternative beta, the set of risk factors that can be replicated using public market instruments.”

Ye added that hedge funds might invest in public securities, but they generally allow investors to access their money only quarterly, semi-annually, or even less frequently.

“The hedge fund itself, for example, might be liquid, but it doesn’t necessarily offer investors daily liquidity,” she said.

Of course, an ETF provider might have good reason to suggest that more institutions are seeking alternatives exposure through ETFs. But the Greenwich study bears out that institutions are using liquid alternative ETFs as part of the core of their portfolios as well as to replace both funds-of-hedge funds and direct investments in alternatives, including single strategy hedge funds.

Replacing funds of funds with a rules-based ETF that provides something similar makes sense, argued Ye. “Funds of funds add an additional layer of fees that is sometimes hard to justify,” she said.

Greenwich expects much of the increased use of liquid alts ETFs to also come from first-time investors — those that currently don’t have an allocation to alternatives, but want to add downside protection out of fear that the bull market will soon come to an end.

[II Deep Dive: Cliff Asness: Stick With Liquid Alts]

The study also found that institutional investors are using liquid alternative ETFs for tactical reasons. For example, they may use these ETFs as they transition out of one hedge fund manager to another. “They don’t want to sit in cash while they make a new decision about a manager,” said Ye.

But “more than 60 percent of institutions say they are more likely to employ liquid alt ETFs for long-term strategic purposes (defined as holding the investment for more than one year), as opposed to short-term or tactical purposes,” the report said. 

Liquid alt ETFs are still relatively new for institutions. “Only about 1 in 10 institutions have experience investing in the funds. However, about the same share of institutions say they are actively researching liquid alt ETFs for possible use, and an even bigger proportion say they might consider investing in the funds in the next 12 months,” according to the study.

Greenwich reported that institutions that use liquid alt ETFs invest an average of 3 percent of total assets in the products. Hedge funds and real estate are the most popular categories.

Eighty percent of respondents in Greenwich’s survey cited liquidity as the benefit of using ETFs that invest in alternatives, followed by diversification (39 percent). Thirty-eight percent of institutions say they like liquid alt ETFs because of transparency. Given investors’ angst over fees, it’s surprising that only thirty-five percent of those surveyed cite lower fees as the benefit of liquid alt ETFs. 

Funds of funds are a common target. 

“Almost 1 in 5 study participants is considering replacing a portion of their funds-of-funds allocation with liquid alt ETFs in the next 12 months,” according to Greenwich.

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