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ETFs emerging as important part of alternative investment market

Exchange-traded products are allowing investors low-cost access to asset classes previously available only to institutional investors

Oct 9, 2016 @ 12:01 am

By Sam Masucci and Barney Karol

Exchange-traded products are becoming an important part of the alternative investment market.

ETFs have and will continue to “democratize” the investment world by allowing investors low-cost access to asset classes previously available only to sophisticated institutional investors. At the same time they are an increasingly important tool for those institutional investors who use ETFs for both basic and custom exposures. Institutions that would never use a conventional mutual fund will use an ETF if it delivers a desired exposure more efficiently than a competing future, swap or separate account.

Since the ETF wrapper does not have the embedded distribution costs and commissions of many traditional products, it will benefit from the Department of Labor's fiduciary rule as well. This is an important consideration, as the Securities and Exchange Commission is also considering extending fiduciary standards to retail brokerage accounts.

The ETF/ETP wrapper is valued in basic investment strategies for reasons such as liquidity, transparency, low cost and tax advantages. However, it also has tremendous utility in creating investment products in alternative asset classes. The definition of “alternative” can vary, but the wrapper can be used to create products that provide access to most commodities, real estate, cash flows, thematic equity and leveraged exposures.

Depending on one's definition of alternatives, there are many already successful alternative ETFs

PRECIOUS METALS

Depending on one's definition of alternatives, there are many already successful alternative ETFs. For example, ETFs have been very good plays on the rising precious metals market, and United States Oil Fund (USO) has been the dominant oil product for some time. ProShares and Direxion products provide leveraged equity exposure.

While the low-hanging fruit of basic exposures has been picked, we believe there are many interesting alternative strategies yet to be packaged in an ETF wrapper. The wrapper will allow those ideas to be mass-produced rather than hide in a high fee. This competition is a factor contributing to the current woes of the hedge-fund industry.

We believe there is also a market for niche strategies. Many of these will come from managers and others now offering a custom strategy in separate accounts and from market professionals who wish to launch an entrepreneurial strategy based on their market insights.

Every new investment idea has its own regulatory issues that must be carefully analyzed. The 1940 Act wrapper accommodates simple equity baskets, but can present challenges as products become more complex, forcing them into the less user-friendly 1933 Act wrapper for “exchange-traded products.” In addition, the SEC seems determined to limit the 1940 Act ETF to products that meet its investor protection standards. For example, the agency recently issued a release that would essentially prohibit the issuance of highly leveraged ETFs in the 1940 Act wrapper.

The niche aspect of these funds will make attaining critical mass more challenging, especially given the proliferation of ETF products. Shelf space is the challenge. Timing, patience and education are also key. Certain strategies, such as rising interest-rate protection ETFs, will be successful only when the underlying event occurs. Some strategies are useful only in certain circumstances, and issuers must be willing to wait for those moments.

(Related read: Schwab cuts ETF fees again, as expense war with rivals BlackRock, Fidelity and Vanguard heats up)

Sometimes a client will provide the demand. Institutional investors can go to an ETF provider with a request for a “bespoke” fund built according to certain specifications, and can then seed that fund with significant amounts, (as much as $250 million with the SHE ETF funded by the California State Teachers' Retirement System, which focuses on female-led companies).

Others will come from “self-seeding” — when an investment adviser converts an already well-funded separate account strategy to an ETF. This can create the critical mass necessary to get on broker-dealer platforms.

Sam Masucci is CEO and Barney Karol is president of the ETF Managers Group.

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