Here’s a question I’ve been puzzling over lately: Why don’t ETF buyers seem interested in investing in alternatives via index-tracking funds?
Issuers have done the hard work of making these ETFs available. But while they now come in all shapes and sizes, they have in common the fact that AUMs remain vanishingly small. Is it because most investors think alternatives are a game for active fund managers only?
Now by alternative ETFs, I don’t mean the ‘standard’ stuff such as REITs, infrastructure or commodities. On paper they appear to tick the alternative box, but if we’re all honest with each other they are in reality risk-on, easy money, liquidity-fueled asset classes that are likely to be highly correlated with, say, growth equities in a really big selloff. And the whole reason asset allocators seek out alternatives is because they hope these assets will provide diversification benefits.
Although I’d argue that there’s more to it. Alternatives should also provide the promise of absolute returns; that is, they will make positive gains over the long term despite the direction of the wider stock markets. I think this is crucial, as I can think of many niche asset classes that are lowly correlated with growth assets but have provided absolutely dreadful negative returns over many years. Yes, we want diversification – but of a positive kind.
Even better is if alternatives can provide insurance against a regime shift. What I mean by this is that investors seek protection against a massive policy shift instituted by central bankers. That may be the shift from quantitative easing to tight money, or from deflation to inflation. The point is that such policy shifts tend to trigger financial regime shifts that can be gut-wrenching at the portfolio level and requires some form of insurance.
I would finish with one last characteristic – ease of access and liquidity. Modern, transparent, liquid markets favor those structures that can allow almost instantaneous buying and selling over-the-counter or via dark pools. And exchange-traded funds is the most liquid form of securities structure, partially becuase they are the best fit for modern trading systems.
Let’s now confront the elephant in the room: Why are the ETFs filled with these sorts of alternatives so unpopular?
Arguably the two most successful issuers in this space have been IG Hedge and Cambria. The former has focused on developing hedge fund replication strategies, and to date its Multi Strategy and Merger Arbitrage funds have gathered a decent but not exactly excited following, with $1.5bn in assets for the two funds combined. Even more surprising for those worried by a policy regime shift is that WisdomTree’s Managed Futures ETF has gathered a measly $150m for an investment strategy explicitly designed to capture policy regime shifts. Meanwhile, over in a related space, Toros’s RPAR Risk Party approach has gathered a decent $1.4bn.
Cambria also deserves some credit for its adventures in alternatives land, most specifically for its Tail Risk ETF, which is an actively managed fund that hold cash and bonds while buying downside put options on the S&P 500. Assets under management are $350m, which I think is a decent number for a specialist house but still a drop in the ocean compared to the giant ETFs.
Sticking with that mention of options in the Cambria Tail Risk fund, another surprise for this observer is the underwhelming support for structured outcome or structured product style ETFs. Specialists such as TrueShares have pushed these defined return and managed risk structures to a market that in truth doesn’t seem terrifically excited by the prospect.
Again, I find this slightly confusing. In much of the rest of the world, structured products to manage downside risk is a hugely popular alternative diversification tool. In the UK, for instance, there’s a sizeable – though by no means huge – segment of the market built around auto-callable structures based off key equity benchmarks. The idea here is to build a product that generates a defined annual return even if markets sell off in the short term. On paper it looks like you are correlated to a benchmark like the S&P 500 or the FTSE 100, but in reality, it’s a play on investment bank risk (the banks structure the options layer, forcing you to take a view on counterparty risk).
If we pull back from these varying solutions, I think a central point emerges. Alternative ETFs are not proving that popular, at least by comparison with the mega ETFs used by most portfolio builders. And this is all despite the hard work of issuers, who seem to be working overtime to come up with novel strategies.
Why the reluctance to embrace alternative ETFs at scale? In terms of returns, IG Hedge’s ETFs, for instance, have for the most part delivered what you’d expect: single-digit returns from quant-led strategies. That’s true for structured outcome ETFs as well.
Maybe advisers are worried about something more fundamental. They may fear that you can’t have a very liquid fund structure in an alternative asset classes that are sometimes defined by their inherent illiquidity. That’s a sound concern for many deeply alternative assets such as art, for instance, but for most hedge fund strategies and structured product-influenced ideas, that’s not a real concern. There’s plenty of liquidity available from big investment bank counterparties.
I think the real driver is a villain I’ve long pointed to in these columns: A central bank liquidity-fueled momentum drive to invest in growth equities. Part of this also comes down to long-term profits from the bond bonanza of the last few decades. Huge profits have been made from buying bonds that are now being actively recycled into crowded equity trades that generate excited talk of disruption and technological change.
A related challenge has been the persistence of the old 60/40 portfolio blend – 60% in equities and 40% in boring bonds. As a diversifier it has worked a treat over many decades, but in my view it is now as dead as the dodo. When the next really big selloff comes, classic 60/40 portfolios will be devastated, since most liquid asset classes auto-correlate toward the investment singularity! If ever there was a need for proper alternative diversification, that time is now. ETF buyers just need to work out what their strategy will be to survive the impending crash.
I finish with one small hopeful sign. Despite my downer of alternative ETFs, there are some encouraging, isolated signs that a few products might sneak through the indifference barrier. I’d particularly watch the growth of carbon pricing ETFs, notably KraneShares’s Global Carbon ETF, which has already accumulated just under a billion in a short time. Carbon pricing has the potential to be a classic diversifier, with low correlation to equities and bonds, and no real impact from central bank policy changes.