Are Alternative Investments and ETFs Compatible?

This past week I was a guest on my friend Nate Geraci's podcast, ETF Prime. In addition to hosting ETF Prime, Nate is President of the ETF Store and a co-founder of the ETF Institute. In short, he's forgotten more about ETFs by breakfast than I have learned in my lifetime. 

You can find ETF Prime on all the major podcast apps, but here is a direct link to my segment on last week's show: 

Savant Wealth’s Phil Huber Goes In-Depth on Alternative Assets (ETF Prime)

In our ~20-minute conversation, we covered a lot of ground with an emphasis on the alternative asset landscape and the role of alts in a portfolio. Given Nate's background, the question naturally came up:

Are Alternative Investments and ETFs Compatible?

While the obvious answer would seem to be 'yes' given how ubiquitous ETFs are today as the default product choice for millions of investors, the reality is not so cut and dry.

Exchange-traded funds have literally transformed the way we invest, bringing lower costs, improved access, heightened transparency, and greater tax efficiency to just about every corner of public stock and bond markets around the globe. But for all of the good that ETFs bring to the forefront, the fund structure's benefits don't necessarily translate to every single asset class or investment strategy. This is particularly true for items on the less liquid end of the spectrum, or for any strategy that needs to be mindful of capacity constraints. 

In addition to sharing my perspective on the subject in my interview with Nate, I also wrote about it extensively in my book, The Allocator's Edge: A Modern Guide to Alternative Investments and the Future of Diversification.

Below is a modified excerpt from Chapter 10 of the book, titled Containers and Contents—Matching the Right Structure with the Right Investment.

You wouldn’t wrap leftover spaghetti in Saran wrap. Nor would you leave your diamond ring sitting in the glove box of your car. Speaking of cars, you probably wouldn’t fill a Jetta with jet fuel. All of this is to say that matching the right contents with the right containers matters.

When an allocator becomes comfortable with a particular asset class or strategy they want to invest in, the next question is which investment vehicle or structure is best suited to access it. Allocators are faced with a variety of fund wrappers to house their investments. Some are appropriate only for certain types of investors, and others are appropriate only for certain types of investments.

There are many considerations to weigh when evaluating the various containers one can invest in, including:

• Targeted asset class or strategy
• Liquidity, or lack thereof
• Investor qualifications
• Taxation
• Trading
• Fund lifespan
• Costs
• Transparency
• Regulatory protections
• Use of leverage, short selling, and derivatives
• Manager compensation

For traditional asset classes like publicly traded stocks and bonds, open-end mutual funds, ETFs, and separately managed accounts (SMAs) generally check all the right boxes and are sufficient. When we enter the realm of alternative investments, we must dive deeper. Several categories can be effectively managed in daily-liquid, SEC-registered funds whereas others cannot.

The Investment Company Act of 1940

The Investment Company Act of 1940 (’40 Act) is an historical piece of legislation that served as the catalyst for the modern era of mutual funds and ETFs. It helped establish trust between investors and asset managers as it relates to things like transparency, independent oversight, and fiduciary duty. Characteristics we take for granted today—like daily NAVs, the use of custodians, leverage limits, disclosure of fees and holdings, simplified tax reporting—are lynchpins of the mutual fund and ETF wrappers governed by the ’40 Act.

Liquid Alternatives

Since their creation in 1924, open-end mutual funds have done a world of good for investors. They have helped democratize access to public stock and bond markets, while also providing transparency, regulatory protection, client-friendly tax-reporting and liquidity to end investors. To be sure, this wrapper is not without flaws—no pooled fund structure is perfect. Some critics would point to the lack of intra-day liquidity as a blemish. Others may view that as a feature, not a bug. The main critical design flaw is the propensity of mutual funds to distribute year-end capital gains, which can cause headaches for taxable investors who are punished at the expense of departing shareholders.

ETFs, also characterized as open-end funds registered under the ’40 Act, have supplanted mutual funds as the default investment vehicle of choice for many investors. While total ETF assets are still roughly one-third of that of mutual funds, asset flows tell a different story. Were it not for the powerful force of inertia, it is likely the gap would close sooner than later.

Relative to mutual funds, ETFs provide not only the intraday liquidity that many seek but also bring increased holdings transparency and added tax benefits thanks to how ETFs create and redeem shares.

As much as ETFs have overcome some of the hurdles that mutual funds faced, they also fall short in some respects. For starters, ETFs have no great way to limit capacity or close funds to new assets, which can be detrimental to certain strategies. There is also the potential for tax leakage to the extent that derivatives are unable to benefit from in-kind redemption -  the feature that makes ETFs such a tax-efficient vehicle in the first place - the same way individual securities are.

As it relates to the use of alternative investments, mutual funds and ETFs can both be great in some cases and lousy in others. This has largely to do with ’40 Act regulations around the use of leverage, short sales, derivatives, and illiquid securities. For alternative assets that require little or none of the above, a mutual fund or ETF can make a great deal of sense from a convenience standpoint. In other instances, the limitations of the structures can lead to a watered-down version of a strategy that might be better run in a semi-liquid or illiquid structure.

Where mutual funds and ETFs fall short in their ability to deliver alternatives is when illiquid investments or performance fees are involved. Technically, there can be performance fees levied in mutual funds, but they must follow a fulcrum fee structure where the fees swing equally both ways. From an illiquidity standpoint, mutual funds are capped at holding less than 15% of their value in assets deemed to be illiquid.

Examples of alternative asset classes and strategies that can work well in mutual funds and/or ETFs are: catastrophe bonds, managed futures, event-driven, long/short and market neutral equity, alternative risk premia, multi-strategy liquid alternatives, public REITs, public infrastructure, gold, and commodities. Even Bitcoin would seemingly work quite well in an ETF, assuming that at some point the SEC approves one. 

Making the Right Choice

It’s clear that demand for alternative investments is increasing, most notably from those who have been excluded from such investments in the past. As this is new terrain for many, prudent matching of the containers and contents of an investment is key to success. While it may feel like we’re stuck in a paradox of choice with the number of investment vehicles allocators must sift through, we can narrow the funnel by first determining:

• Which alternative asset or strategy we are targeting.
• What liquidity preferences or needs our clients have.
• Whether they meet potential investor qualification standards.

Too much choice can be overwhelming, but at the same time we are now entering what could be a golden age of optionality and access that hasn’t existed before within alternatives.