Review & Outlook

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‘Liquid Alternative’ ETFs: Making a Bad Idea Worse

21 October, 2014 by Matthew O'Brien, Ph.D. in Commentary

We’ve written a number of skeptical posts on the recent broker-led push for “liquid alternatives,” which are hedge funds investment strategies offered through mutual funds.  Now comes this report from Bloomberg News that Goldman Sachs is considering buying IndexIQ, a firm that provides hedge funds wrapped not in mutual funds, but in exchange-traded funds (ETFs).

Mutual funds, which have their net asset values determined once daily, are required to provide liquidity to their shareholders each day.  ETFs, by contrast, are traded on market exchanges throughout each day, so they must provide momentary liquidity as long as markets are open.  ETFs are made possible by complicated market-making activities and in-kind exchanges.  Liquid alternative mutual funds are a bad idea because most alternative assets are of their nature illiquid, and holding illiquid assets through a liquid wrapper doesn’t make the underlying illiquidity disappear.  Rather, the liquidity mis-match between investment vehicle and underlying asset creates a new kind of risk borne by the shareholder.  His ownership of the underlying assets becomes subject to the sentimental whims of other fund shareholders, who may imprudently cause forced selling in times of panic.  ETFs are more liquid than mutual funds, so they aggravate the liquidity mis-match and potentially create an even greater risk.

I met a private banker recently at the Financial Times Investment Management Summit who in conversation put the problem with liquid alts in the this way: if hedge funds charge their L.P. investors 2 and 20, and they offer the identical strategy through a liquid alt mutual fund for just 2%, without a 20% incentive fee, then all of their hedge fund clients will migrate to the mutual fund since it costs much less.  Therefore, hedge fund managers are incentivized to offer only sub par strategies through mutual funds, otherwise they will just end up cannibalizing their existing hedge fund clientele and end up making less money.

The same logic would seem to hold, a fortiori, for liquid alternative ETFs relative to liquid alt mutual funds.  In any case, liquid alt ETFs are yet another innovative Wall Street product that everybody would be better off to avoid.