Looking for liquid alternatives

It was privilege to attend the sixth annual ETF.com Inside ETFs conference in Amsterdam earlier this month (8-10 June), even if the inside of two taxis, the venue and Schiphol airport were all I saw of the beautiful Dutch city. The event covered a huge range of topics related to Exchange-Traded Funds (ETFs) and it was a particular pleasure to participate in a panel with Claus Hecher of Germany’s Deltaoneacademy, freelance journalist Paul Amery and Adam Laird of our good friends at Hargreaves Lansdown, where we discussed the pros (and cons) of so-called Liquid Alternatives (also known as “liquid alts”).

Alternative asset classes include portfolio options such as hedge funds, real estate, private equity, niche commodities like timber and even volatility. They are beginning to attract greater attention from investors, not least because in principle they can offer something most people would like in their portfolios: the potential for absolute returns; diversification, thanks to their limited correlation to mainstream asset classes (such as equities and bonds) and the scope for offering downside protection in the event of a broader financial market downturn.

The hard part is gaining access in a manner which suits an investor's specific needs and financial circumstances. Hedge funds, for example, often come with high barriers to entry, notably lofty minimum investment requirements, as well as limited transparency, varying levels of regulatory protection, chunky fees and above all poor liquidity – investors may only be able to sell and withdraw cash once a quarter (or less frequently still during times of market stress, as was seen during the financial crisis in 2008).

Exchange-Traded Funds which provide exposure to hedge funds can, in theory, tackle these issues, particularly that of liquidity, since by their very nature they are designed to be tradeable on an intra-day basis, and hence the term “liquid alts”. There are five such vehicles traded in London and they are listed in the table below, although two come in different currencies (dollars or hedged back to sterling). Further ETFs dedicated to hedge funds, can be found on exchange in Europe and in the US, although in the latter case investors may need to check on issues such as withholding tax and even take financial advice.

Clients can choose between five London-listed ETFs which follow hedge funds

Source: AJ Bell Research Centre, Morningstar. Covers the Alt – Fund of Funds Equity and Alt – Fund of Funds Multi-strategy categories

Liquidity, liquidity everywhere but not a drop to trade

Before going any further, it may be worth addressing the issue of “liquidity” and exactly what it means. In an era of Level 2 market access and reliable online trading and stockbroking platforms this is a concept that is often taken for granted. This is dangerous as it suggests the lessons of the 2007-2009 financial crisis may have been forgotten, even if spring’s ructions in the European sovereign bond market represent a timely reminder.

Most investors probably take liquidity to mean the ability to buy or sell a security in decent size on a recognised exchange as and when they wish to do so. Yet surely the real definition of liquidity is the ability to buy or sell a security in decent size on a recognised exchange as and when they wish to do so at their desired price. This is the lesson of the crisis. Investors can nearly always sell when the going gets tough but the problem is they may have to do so at a lower price and possibly in smaller size than they would like, further damaging their chances of liquidating further positions at advantageous levels. In a worst case, there will be little or no liquidity at all, as investors who had put cash into real estate funds, private equity funds or hedge funds found to their discomfort. These collectives on some occasions went in to lockdown, and imposed restrictions on client withdrawals of cash for periods of a year or more, so the funds themselves did not become forced sellers of their often illiquid underlying holdings.

Liquid alts

The acerbic twentieth century American writer and with Dorothy Parker once wrote: “Love is like quicksilver (mercury) in the hand. Leave the fingers open and it stays. Clutch it, and it darts away.” Investors should perhaps think of market liquidity in the same way, as the ability to trade at desired prices is there in bull markets but rarely if ever in a bear market, which is when they really need it.

In theory, “liquid alts” and ETFs which provide clients with the performance of potentially illiquid underlying asset classes are designed to address this need. Property ETFs tend to hold baskets of real estate investment trusts (REITs), quoted constructors or managers of buildings used for commercial purposes. The db X-trackers LPX MM Private Equity UCITS ETF (ticker: XLPE) holds positions in 25 quoted private equity firms, such as the UK’s 3i and America’s Blackstone and KKR.

Performance of db X-trackers LPX MM Private Equity UCITS ETF since listing in London (ticker: XLPE)

In principle the ability to buy or sell an ETF intra-day means clients can participate in an asset class which may have otherwise been difficult for them to access. With particular reference to hedge fund ETFs, it is important to understand how the instruments work and actually seek to deliver, or track, the performance of the underlying assets, before their potentially advantages (and disadvantages) can be fully assessed. Note that an ETF should be able to deliver pretty much the whole range of hedge fund strategies, from activist to event-driven, merger and acquisition arbitrage, macro, futures, market neutral, long/short, multi-asset and so on.

Remember that an ETF cannot directly invest in hedge funds. They must provide daily liquidity and be freely tradeable to maintain their European UCITS regulatory status, whereas hedge funds often have limited time windows for buying or selling. As such, hedge fund ETFs tend to follow one of three strategies:

• Hedge fund ETFs can directly hold the underlying securities and almost behave like a hedge fund themselves, buying stocks or bonds, other ETFs and even holding inverse ETFs, which rise in value when the underlying asset falls in price (and are thus the equivalent of “going short”).
• Hedge fund ETFs can track and replicate the performance of a hedge fund index. Hedge funds can be secretive but they will report performance data to a specialist provider of hedge fund indices. That specialist will then custom-build an index that reflects the performance of all hedge funds in a given category, depending upon their strategy. The ETF will then seek to replicate the performance of the index as best it can by holding assets which fit best with the hedge funds’ approach. This will often be achieved by holding other ETFs and as such the ETF provider will tend to map the hedge funds’ return profiles and then select liquid assets to fit this, using proprietary regression analysis models.
• Hedge fund ETFs can act like copycats and mimic the holdings of leading hedge funds, subject to screens such as the money managers' track record. Regular readers of this column may be familiar with the Global X Guru Index Exchange-Traded Fund, which trades on the NYSE Arca under the ticker of GURU. It tracks the performance of the Solactive Guru index, which is turn measures the price movements of the top US equity holdings of a select group of hedge funds, based on the quarterly regulatory declarations to the Securities and Exchange Commission known as 13F filings.

Upside and downside

The advantages of “liquid alts” and ETFs which seek to replicate the performance of hedge funds are potentially as follows:

• Costs should be lower. Many hedge funds charge 2% a year and then take 20% of any profits. Hedge fund ETFs offer total expense ratios of around 0.3% to 0.5% in the UK with no performance fee.
• Transparency is greater, as ETFs have to disclose the nature of their holdings and underlying collateral on a daily basis, whereas hedge funds may report monthly or even quarterly.
• ETFs are UCITS instruments and as such tightly regulated, whereas hedge funds are not.
• Hedge funds ETF are by their nature designed for trading every day and should therefore be in theory more liquid than hedge funds, which frequently offer a limited and pre-set time period for adding or withdrawing funds.
• “Liquid alts” such as hedge fund ETFs offer portfolio diversification  and attempt to offer “all-weather” performance, with low correlation to mainstream assets and even the potential for positive returns during market downcycles.

There are however potential disadvantages:

• The total expense ratios associated with “liquid alts” tend to be higher than those charged by vanilla ETFs tracking well-known benchmark indices
• It is still hard to judge just how tradeable liquid alts are. The arrival of a consolidated tape under MiFID-2 in 2017 should however make this easier.
• “Liquid alts” which track a basket of funds could end up delivering the performance of an “average” fund in this area, rather than the best-in-class and the replication mechanism means the investor does not own the hedge fund's underlying assets
• By their nature “liquid alts” potentially remove one benefit of owning illiquid assets, namely the illiquidity premium
• Hedge fund performance simply has not been very good. According to research from Goldman Sachs, the hedgies have underperformed America's S&P 500 for six straight years and exceeded it just three times in 12.

Portfolio planning

In the end, whether exposure to alternative assets classes, liquid or not, is suitable for an investor will be for them, according to their own individual financial goals, time horizon, target returns and appetite for risk. Moreover, these are relatively new products, at least in the UK. Portfolio-builders may decide to observe further before acting especially as it is only in a bear market will we truly see whether “liquid alts” prove to be liquid all the time, whether they do offer uncorrelated performance and whether they can protect the downside or even generate positive returns (especially on the hedge fund side).

For the moment, the performance of the London-listed hedge fund ETFs looks solid enough and with limited volatility for good measure.

Performance of db X-trackers db Hedge Fund Index UCITS ETF 3C (GBP Hedged) since listing in London (ticker: XHFG)

Performance of UBS HFRX Global Hedge Fund Index SF UCITS ETF (USA) A-Acc USD since listing in London (ticker: UC19)

Performance of db X-trackers db Equity Strategies Hedge Fund Index UCITS ETF 3C (GBP hedged) since listing in London (ticker: XHEG)

Nevertheless, any investors who are in a hurry may ponder why they would need to pay 0.3% to 0.5% a year in total expense ratios (TERs) for instruments which are up 5% to 10% when ETFs tracking “vanilla” equity benchmarks like America’s S&P 500 or Japan’s Nikkei 225 have done better and done so at a fraction of the cost (such tools can now often be bought for an annual TER of 0.1% or less)

A final point to consider is whether liquidity is always a desirable feature of an investment. As already noted, one reason to hold hedge funds or private equity or infrastructure assets is the potential for higher return, helped by the illiquidity premium, that can compensate for the higher risks. Patience can be a virtue. By contrast, liquidity can tempt people to overtrade and incur unnecessary costs, in the form of bid/offer spreads, commissions, management fees and even tax. Just because they can buy and sell something relatively freely does not mean they should. As Warren Buffett once said: “Investors should remember excitement and expenses are their enemies”, adding on a separate occasion, “For investors as a whole, returns decrease as motion increases.”

Further study

In the interests of space, this analysis has primarily looked at just ETFs which provide access to hedge funds, but as noted at the start, these instruments can be used to glean exposure to a range of alternative asset classes. For those who would like to know more about “liquid alts”, the ETF.com team’s website provides regular in-depth coverage, while a visit to www.DailyAlts.com will always prove informative. This column will also endeavour to maintain a watching brief as the market develops and further performance data become available over time.

Russ Mould
AJ Bell Investment Director