Peanut Butter and Jelly. Batman and Robin. Rock ‘n roll. Sometimes, two things are just made for each other. Perhaps, when it comes to investing, the perfect pairing could be found in active exchange-traded funds (ETFs) and so-called liquid alternatives.
Despite their diversification benefits and ability to generate non-correlated returns/income, liquid alternatives, or alts, have been largely ignored by investors. And there are numerous reasons why this is a fact, which is a shame because these hedge-fund and sophisticated strategies are just perfect for an environment such as the one we’re in, or could enter when the Fed raises rates.
But the use of liquid alternatives could finally grow as active ETFs continue to dominate both the conversation and investor portfolios. Thanks to their structure, active ETFs could be one of the best ways to house liquid alts in a cheap and easy-to-use package. Here, we finally could see the promise of alts as portfolio tools for the masses.
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Liquid Alts - the Basics
According to Modern Portfolio theory, the reason why we hold bonds, stocks, real estate, etc., is to seek diversification and improve long-term returns. The problem is, we confuse diversification with correlation, meaning that that is how two asset classes such as U.S. stocks and Treasury bonds move together. If you hold a portfolio of 25 different asset classes and their correlations are similar then it really doesn’t matter that you hold a diverse basket of assets. They’ll all move in the same direction.
Real diversification means that your portfolio’s holdings move in different directions and magnitudes under various conditions. Losses in emerging market stocks are buffered by gains in silver, for example.
The problem is that traditional asset classes used for diversification are now getting more and more correlated. Stocks and bonds are moving in the same directions as low interest rates switch up the relationship.
This is where alternatives can come in. Not only do they represent asset classes that are outside traditional norms, like carbon credits, alternatives can include strategies like 130/30, market neutral or merger arbitrage. These alts can be key to solving the diversification dilemma. Wall Street has been happy to oblige. These strategies have been packaged into mutual funds, ETFs and other vehicles.
Expensive to Hold
Despite their promise of providing absolute and non-correlated returns, liquid alternatives have been mostly a flop when it comes to retail investors’ portfolios. One of the major reasons has been their high cost of ownership.
Thanks to the explosion of passive ETFs and the success of mutual fund shop Vanguard, investors have fees on their minds. And thanks to this fact and the so-called ‘fee war,’ the average cost for owning a passive broad-based index fund is basically free at this point. Mutual funds have followed suite and have continued to reduce their fees as well.
But when it comes to liquid alternatives, expenses run high.
According to Morningstar, the average liquid median expense ratio for liquid alternative mutual funds is a high 1.66%. But some liquid alt funds charge over 3%. Additionally, liquid alternatives are still one area where sales loads and 12b-1 fees reign supreme. Some of that high fee is justified as liquid alternative funds require a lot of hand holding from managers and some of the asset classes, like managed funds- are harder to trade than Treasury bonds or large-cap equities.
The problem is that this high fee hurdle causes problems on the return front. By definition, liquid alts funds are designed to not hit it out of the park, but provide steady constant returns. So, when a manager has to clear 2% in expenses, earning a 3% return doesn’t cut it. So, investors have largely skipped alts in their portfolios.
Active ETFs Could be Alts Savior
But the win in alternatives could come from the surge in active ETFs. It turns out that ETFs could be the perfect fund vehicle to hold the strategies.
For one thing, it’s a lot cheaper to run an ETF than it is a mutual fund. As a result, expense ratios for active ETFs in the category are much lower. For example, the ProShares Managed Futures Strategy ETF (FUT), which follows a systematic trend strategy, only charges 0.75% in expenses, while the options-focused Nationwide Risk-Managed Income ETF (NUSI) only charges 0.68%. While not as cheap as a bread & butter S&P 500 ETF, those are much easier expenses to swallow and overcome with returns. You can see those lower expenses come into play in the better than mutual fund returns for some of the oldest active alternatives ETFs.
Secondly, active ETFs could be a great vehicle for liquid alts in another way: investor redemptions. Because they track some esoteric asset classes, liquidity in alts funds can be a problem. Many are structured as interval funds or unit investment trusts. Here, investors can only make redemptions or add new money after certain lock-up periods end. But because ETFs buys/sales take place in the secondary market due to the creation/redemption mechanism, investors can have the benefits of hedge funds and alternative strategies with needed liquidity.
Finally, active ETFs could give smaller investors a way to add alternatives in the first place. Again, because of their strategies and what they hold, most alternative funds require some hefty initial investments. For example, the AQR Alternative Risk Premia Fund (QRPRX) requires an initial investment of $100,000. And this isn’t the fund’s institutional shares. With an ETF, all it takes is one share to add alts.
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Alts & Active ETFs Go Hand & Hand
Overall, investors have been slow to adopt liquid alternatives in their portfolios. But active ETFs could level the playing field and get more people into the asset class. In the end that could mean better diversification for investors’ portfolios.
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