Why Alt ETFs Have Yet To Take Flight

Alternative ETFs are languishing despite a perfect storm.

Reviewed by: Jamie Gordon
Edited by: Jamie Gordon

[Editor’s note: This article originally appeared on ETF Stream]

London – Alternative ETFs have re-entered the discussion as monetary policy fears see investors hunt for diversification – but there is still a rift between the broad array of alt assets and the slim range of ETFs targeting this often-elusive group.

Despite the Federal Open Market Committee’s (FOMC) best efforts to reassure investors that it will keep rates “lower for longer”, some market commentators remain sceptical, while others anticipate a repeat of the 2013 taper tantrum, whereby the Federal Reserve shuts off its asset-buying tap.

In the event that policymakers hike rates to stymie inflation, this poses a downside risk to most equities as borrowing costs increase. On the tapering side, the Fed’s recent announcement that it will start selling off its fixed income ETFs will only compound bonds’ tough start to 2021 by further depressing prices.

This uninspiring backdrop – which typically follows generous central bank support during a recovery – is where non-correlating alternative ETFs should come into their own. 

“Alts have the potential to add return and reduce volatility particularly as the future returns from high grade fixed income look limited and as their diversification benefits fall,” Peter Sleep, senior investment manager at 7IM, said. 

Sleep added commodities have stood out as the main alternative ETF asset class since they entered almost two decades ago but aside from the recent upsurge of crypto exchange-traded products (ETPs), he remains unconvinced that ETFs offer the best access to other kinds of alt assets. 

Prior to gold’s 2% price dip last week, net long positions on the precious metal were at a four-month high and exchange-traded commodities (ETCs) tracking gold were among the most traded ETPs in Europe in 2020.

Highlighting this, the iShares Physical Gold ETC (SGLN) and the Invesco Physical Gold ETC (SGLD) saw the top two inflows across all ETFs in Europe last year with $4.9bn and $4.6bn net new assets, respectively, according to data from ETFLogic.

Noncorrelation Comes At A Cost

One thing that has allowed gold to cultivate its position as a go-to non-correlating asset for ETF investors has been the stiff competition between issuers, Matt Brennan, head of passive portfolios at AJ Bell, said.

“There has been a price war in gold, and this has led to a virtuous cycle of price cuts, making the asset class very cost-effective for an investor,” Brennan noted. 

Unfortunately, the same cannot be said for other alt exposures being targeted by ETFs with run-of-the-mill methodologies.

For instance, Brennan highlights the iShares UK Property UCITS ETF (IUKP) and iShares MSCI UK Target Real Estate UCITS ETF (UKRE), which offer exposure to property and both have fees of 0.4% apiece. While UKRE offers a blend of real estate investment trusts (REITs) and index-linked gilts within its basket, IUKP is predominantly REITs, making it a pure equity strategy. 

“I have never really understood why REITs as a product have been priced so highly – when speaking to Blackrock, it has previously been explained as a lack of demand/capacity, but I would argue, that unless the prices are lowered here, the demand will not come,” Brennan said. 

The same scenario is played out in the asset class brought back into vogue by US President Joe Biden’s extensive fiscal stimulus – infrastructure. The guilty culprit here is the iShares Global Infrastructure ETF (INFR), which carries a fee of 0.65% for its basket of infrastructure-related stocks. 

Infrastructure ETFs buoyed by Biden early-term spending

“I can get either an active open-ended fund for just a little bit more, or a tracker open ended fund for a lot less,” Brennan noted. 

In sum, Brennan concluded most alternative exposures have fallen flat because although the products are sometimes more complex than ‘vanilla’ equity or bond ETFs, many do not offer enough differentiation to justify their high cost, especially when compared to single-sector ETFs with TERs as low as 0.12%.

“When we expect alternative strategies to deliver inflation like returns, when costs of investing can be up to 1% in some cases, it feels like lots of return is being handed over to the provider.” 

How Alternative?

Touching on the point about lack of differentiation, Sleep noted the liquidity requirements of ETFs mean they are better suited to securities that trade in high volumes, such as equities and bonds. 

The implications of this are two-fold. First, it limits the potential for non-correlation with mainstream asset classes and second, it puts constraints on the range of alts that can be brought into an ETF wrapper.

“ETFs have to be liquid so some traditional areas like private equity, infrastructure or real estate are subsets of the equity market and do not offer great potential for diversification,” Sleep continued. “Many truly alternative asset classes, that diversify away from the equity and bond markets, are quite small and require skill to access.   

“For this reason, actively managed hedge funds tend to dominate the alternatives space.  You will therefore probably have to pay a skilled asset manager for most alternatives.”

So far, investors have seen property and infrastructure equity and bond ETFs, commodity and commodity futures ETFs, and ETFs targeting hedge funds, cryptos and alternative credit among other exposures.

However, there are some liquidity constraints to the wrapper. For instance, individual investors will probably never see an ETF targeting the more niche elements of the alt asset remit, such as collectibles. Incidentally, these are some of the most non-correlated assets, which enjoy spells of popularity while investors rush for diversification.

One solution, Brennan said, would be an attempt to find a halfway house between a vanilla ETF and the investment trust structure, which allows managers of less liquid investments to manage flows without constant primary subscriptions.

“Some alternative strategies are hard to access through a rules-based approach, and this may encourage the growth of ‘active’ or semi-transparent ETFs within Europe,” Brennan said. “An active ETF provides a half-way house between an open-ended mutual fund and a close ended investment trust and may be a suitable vehicle for certain strategies, making discount control much easier, as the market will take care of this element.” 

Not Making The Grade

A final cause for lacklustre uptake in alt ETFs is that to date, some alternatives have failed to offer sufficient returns.

On this, Sleep noted volatility ETPs exist but have shown to be lacking and then pointed to the meltdown of VIX trackers in February 2018.

Brennan also pointed to the JPM Managed Futures UCITS ETF (JPFM), which took long and short positions on different asset classes but joined the company’s other ETFs in closing last year due to poor growth. 

JP Morgan AM closes managed futures ETF

“Perhaps it was just a little bit early in the life of ETFs in Europe to prove a success, but we genuinely feel having ETFs offering alternative exposure in the current bond environment would be welcomed,” Brennan concluded.

Jamie started at ETF Stream as a reporter in January 2021. Previously, he was a senior journalist at the UK Investor Magazine, Investment Observer, UK Startup Magazine and UK Property Journal. He holds an undergraduate degree in politics and international relations, and a postgraduate degree in ethics.