Alternatives ETFs wait for big moment with institutions

Over the last few years, the allocation that large institutional investors have been willing to commit to alternatives has appeared limitless. And the larger the investor, the more likely they were to utilize alts.

With few exceptions, however, alternatives offerings in the $8.3 trillion U.S. exchange-traded product market have failed to attract significant institutional interest. Yet some recent market and product trends have helped to shine a light on the opportunities and advantages of ETFs beyond equity and fixed-income exposures.

Through January, broadly defined alternative ETFs managed just $6.7 billion; currency products sat at $31.9 billion — due mostly to the introduction of spot bitcoin ETFs in January; and commodity exchange-traded products held $126.6 billion, primarily invested in gold and other precious metals funds, according to FactSet Research Systems.

According to the 2023 NACUBO-TIAA Study of Endowments, marketable alternatives made up nearly 18% of assets, on average, for U.S. college and university endowments larger than $1 billion. This category includes hedge funds, absolute return, market-neutral, long-short, event-driven and derivatives-based strategies. Even smaller programs down to $25 million held at least 5.7% of the portfolio in alternatives. State and municipal retirement systems with promised benefits greater than $1 billion held 5% in hedge fund strategies and 6.6% in commodities and miscellaneous alternatives, according to an analysis by Equable Institute. Large institutional alternatives allocations, however, have generally been devoid of ETFs.

Yet, in an October regulatory filing, the roughly $48 billion General Electric Pension Trust revealed an over $100 million investment in the Simplify Market Neutral Equity Long/Short ETF, which was launched in June 2023. The investment "is a shot across the bow of hedge funds all across the U.S.," Bloomberg Intelligence Senior ETF Analyst Eric Balchunas said at a conference in December.

"There's a growing population of hedge-fund like strategies in the ETF wrapper," said Aaron Filbeck, managing director and head of UniFi by CAIA at the Chartered Alternative Investment Analyst Association. These include long/short equity, merger arbitrage and managed futures. "But to get to the liquidity required for an ETF product, what is being stripped out?" Filbeck asked. "You are either sacrificing leverage or an illiquidity premium."

It's unlikely that ETFs will extend into venture capital, private equity or private credit, Filbeck said. Valuation, terms and liquidity on such assets do not make them amenable to the exchange-traded fund vehicle.

In an analysis for Pensions & Investments of U.S.-listed ETFs with strategies outside of long equity or fixed income, FactSet found 51 ETFs with a one-year correlation (R-squared) below 0.05 to both equity and fixed income. Among those products were three long-short ETFs, five bitcoin futures ETFs, and the remaining invested in commodities and commodity futures ETPs. Included in the commodity products are a handful of funds that invest in the burgeoning market for carbon credits.

"Very few of the ETFs that might be expected to provide positive, uncorrelated returns actually delivered, at least to the standard of having a goodness-of-fit of 0.05 or less," said Elisabeth Kashner, vice president and director of global fund analytics at FactSet Research Systems.

Among those that did deliver were the $176 million Franklin Systematic Style Premia ETF (FLSP), a long-short equity strategy seeking exposure to quality, value, momentum and carry. Launched in late 2019, the fund has added $82.5 million in assets and achieved total returns of 16.6% over the three-year period ended Jan. 29.

"Given the increasing correlations of equities, credit and some other alternative assets, clients are always looking for more efficient ways to access non-correlated strategies," said Dan Muzzarelli, head of U.S. ETF distribution at Franklin Templeton. "Interest tends to pick up late cycle."

Pushing those correlations toward zero, however, is challenging. Of the 30 hedge-fund like ETFs that had at least one year's worth of history, 12 had an R-squared value of 0.5 or higher against either U.S. equity or investment-grade bond markets, according to FactSet.

"Commodities and currencies provided better diversification," Kashner said.

Eric Biegeleisen, partner and deputy chief investment officer at 3EDGE Asset Management, which manages $1.8 billion in ETF portfolios for retail, high-net-worth, and small institutions, said his firm regularly evaluates and invests in commodity ETPs, including energy and agricultural futures and precious metals, as part of its real asset portfolio.

He added that many firms like his will manufacture their own long-short or market-neutral strategy using ETFs, rather than buying a packaged product.

Similarly, Dulari Pancholi, partner and head of credit and multiasset research at NEPC, said she has observed investment managers watching ETFs and tracking flows "to get a sense of market movement and sentiment as a measurement to better inform when they might put on or take off a trade." Institutional investors and private wealth clients, however, are not yet looking to bring alternative ETFs into their portfolios, according to Pancholi.

Franklin's Muzzarelli counters that there are some cases where institutions are evaluating ETFs in their market-neutral portfolios. "In this asset class, daily liquidity, transparency and low fees are all tenets that resonate with any buyer," he said.