Liquidity fears dampen alternative ETF allure
While interest grows in new esoteric ETF products, institutional investors are unimpressed with the lack of liquidity in some areas, writes Maha Khan Phillips
The controversy around leveraged and inverse ETFs is just one reason why this summer was not a good time for providers offering more esoteric and complex exchange-traded products. While interest and use of ETFs continue to grow, institutional investors don't always realise what they're getting into, say consultants.
Since 2006, the percentage of users of ETFs has doubled in most asset classes, according to research from EDHEC, the French Business School. While ETF products for the alternative investment universe are still gaining traction, growing dissatisfaction suggests that these gains might be hard to sustain. Satisfaction with hedge fund and real estate products fell in 2009, according to the EDHEC European ETF Survey 2009. Dissatisfaction with hedge fund ETFs, for example, caused a fall from 7% to 5% in their share of total hedge fund investment.
"Satisfaction has been declining for all three asset classes that have had liquidity problems: real estate, hedge funds, and corporate bonds," explains Felix Goltz, head of applied research at the EDHEC Risk and Asset Management Research Centre. "ETFs are trying to offer intra daily liquidity on products that are only computed quarterly, in the case of real estate, and monthly in the case of hedge fund indices."
Chris Sutton, senior investment consultant at Watson Wyatt's Thinking Ahead Group, says that concerns about liquidity in any new alternative product is entirely legitimate in current market conditions. Some alternative asset classes fare better than others. Investing in ETFs based on underlyings in high yield debt, infrastructure and commodities can actually make a good deal of sense. He says: "We would characterise ETFs as a good way of potentially dipping your toe in the water of a new asset class where you don't have extensive research on who the active managers are, and of finding value." As the EDHEC survey reveals, investors are broadly satisfied with commodity ETFs, using them significantly in a core satellite approach.
Products that are faring less well struggle to capture the investible traits of their underlying asset classes, according to consultants. Hedge funds have proved to be the most problematic. "By definition, hedge funds invest in liquid underlying assets," argues Heinz Katsen, principal for Mercer in Germany. "Why would you want to put something like that into an illiquid format?"
There are two ways that providers offer up hedge funds, either by investing in a sample of hedge funds themselves in order to create the index, or by offering up hedge fund replication. "It's not clear to me why an institutional investor would want or need to do this through the wrapper of an ETF," says Sutton.
Hedge fund replication strategies have come under fire in the last year for not offering true hedge fund exposure, while hedge fund index exposure is also controversial. Sutton suggests that there is a negative bias in that only hedge funds willing to accept new money from an index type product can get into the index in the first place.
ETF provider db x-trackers thinks it has solved the problem. "We've launched an ETF linked to an index based on real hedge fund performance. The index is linked to the performance of a portfolio of hedge fund managers which have managed accounts on Deutsche Bank's own platform. The funds have daily NAV," says Manooj Mistry, head of db x-trackers in the UK.
For Goltz, that approach continues to be problematic. "This can only be done with managers that accept daily or weekly liquidity. These kinds of platforms are typically heavily biased towards the more liquid strategies, managers who accept these terms will probably be long/short equity managers, and you won't get much arbitrage."
Mistry disputes this, arguing that the platform is representative of the market as a whole.
Real estate ETFs offer similar challenges to investors, say consultants, because they use real estate investment trusts (REITs) as their underlying component, and the jury is still out about whether this offers genuine exposure to real estate, or simply captures equity beta, providing different risk and return characteristics. EDHEC argues that the indices cannot be considered truly representative of institutional investment in real estate, because of the criteria - listing, capitalisation, and liquidity - on which their components are selected. "There seems to be a trade-off between investibility and liquidity, and a true representation of the asset class," says Goltz.
Product providers and industry participants argue that some of the criticism is unfair, particularly as ETFs can provide major benefits. "The most important trait that ETFs offer is simple access. We have an index that tracks the largest and most liquid companies in frontier markets. For an investor to get an exposure to those markets before ETFs was a very difficult proposition," argues Reid Steadman, global head of ETF licensing at Standard & Poor's.
Other participants believe investors need to be more realistic. Nizam Hamid, managing director and head of sales strategy for iShares in Europe, says that investors have to realise that it's not possible to take an illiquid product and turn into a completely liquid offering. "Investors want certain alternative ETFs but then they aren't happy with the liquidity that they get. They have to ask themselves how easy it would be to access the underlying asset anyway. If you're buying an ETF on a credit default swap index, how easy would it be to trade this directly? An ETF can only be as transparent as its underlying asset."
Katsen believes that part of the issue for institutional investors is that they require different things from an ETF, compared with retail investors. "ETFs are not just an institutional story; they are a retail story as well. I think for the asset managers it's an economy-of-scale issue. They always try to make cross-over products from retail into institutional."
Watson Wyatt's Sutton says institutional investors should look at asset allocation first, and then evaluate the pros and cons of ETFs against other alternatives. "Where ETFs are built around short-term trading strategies, they are not entirely appropriate," he says.
Still, products are growing. The use of ETFs in commodities and corporate bonds has increased significantly, according to EDHEC research, while the use of real estate ETFs and hedge fund ETFS increased only slightly, they are now used by about one-third of investors. While illiquidity poses a real problem for investors, respondents to the EDHEC survey also indicated appreciation for the wide range of asset classes and products made accessibly by ETFs.
It is, say participants, a market with huge amounts of potential, despite the liquidity problems.