A panel session at the Inside ETFs Europe 2016 Conference examined the renewed interest in Liquid Alternatives. This article draws out and expands on some of the key findings from the panel discussion of the same title. The role of alternatives in portfolio construction The role of “alternative” asset classes in portfolio construction has traditionally been to provide differentiated asset returns that reduce overall portfolio volatility through diversification. Alternative asset classes can be broadly defined as non-equity and non-bonds, so typically includes hedge funds, property, commodities, infrastructure and private equity, and subsets of those groups. Lessons from the global financial crisis This classic Markowitz-style portfolio construction approach, based on single period mean variance optimised models was severely challenged in the global financial crisis, when diversification failed to protect assets in the short run (correlations trended to one), and risk-return opportunities became more binary (risk-on/risk-off). Assumptions challenged More specifically, some key assumptions on correlation, liquidity and time horizons that underpin portfolio construction theory required closer scrutiny. Firstly, correlations are unstable, particularly over shorter time horizons. This means that while a static approach to a diversified asset allocation may be adequate in the long run for the long run, in the short run diversification can fail to provide any protection to a portfolio. Hence the need for a tactical asset allocation approach that is dynamic. Dynamic means adapting to the fact that correlations between asset classes are different in the short run to how they are in the long run, and remain in constant flux. It’s therefore important to understand the role and correlation of alternatives to other asset classes across a time horizon that is relevant to an investor, as not all (in fact very few) investors are endowments with infinite time horizons. Secondly, liquidity matters, and matters more when needed most. While portfolio theory assumes perfect liquidity to move between asset classes, the relevance of liquidity became all too apparent in the financial crisis both from a timing perspective and a counterparty perspective. From a timing perspective, the gating of investors in certain hedge funds, and the relevance of redemption notice periods – whether daily, monthly, quarterly or annually – became all too relevant. From a counterparty perspective, solvency, capital structure and legal title became a primary concern. Finally, time horizon matters. For investors with a long-run time horizon who had no need to access capital and could weather extreme market volatility, there was sufficient risk budget not to worry about near-term correlations and liquidity constraints. But for those that needed to access capital in the near to medium term, or wished to dial-down their exposure to all risk assets in the face of potential market dislocation, these factors could not matter more. Industry response Once the dust settled, the industry response to client concerns was to consider how to offer alternative strategies (for the same diversification reasons as before), but with some hard lessons learned. Strategies had to be sufficiently flexible to be adaptive to changing market circumstances, and sufficiently liquid to be bought and sold on a daily basis. “Liquid alternatives” therefore became a buzzword for strategies that can 1) from a portfolio construction perspective, provide uncorrelated returns to traditional asset classes; and 2) from a portfolio implementation perspective, provide daily liquidity. Put differently, liquid alternatives are products that enable investors to trade “anything other than conventional beta”, according to Jean-René Giraud, CEO of Trackinsight, a European ETF research provider that is part of Koris International. Liquid Alts – delivered as mutual funds The growth in “liquid alt” was focused initially in the US mutual fund space (and were sometimes known as 40 Act funds as they were governed by the US Investment Company Act of 1940). The nature of investment strategies offered was therefore governed by what was permissible under the 1940 legislation – for example the requirement to offer daily liquidity, and to calculate a daily NAV. However, this also meant constraints around concentration, excessive leverage and short-selling. While these constraints were more restrictive than private/non-registered hedge funds, this sub-optimality was considered outweighed by investor demand for daily liquidity. Following the financial crisis, there was explosive growth in liquid alt funds, as illustrated in Fig. 1, below: Figure 1: Growth in Liquid Alt Mutual Funds (US) Note: The chart combines the Morningstar Alternative Mutual Funds and Morningstar Non-Traditional Bond Funds sectors to represent a Liquid Alt mutual fund sector.
Source: Spouting Rock, Morningstar Direct, as at 31st October 2015. Morningstar subdivides liquid alt funds into the following sub-sectors: Managed Futures, Long-Short Equity, Multi-Alternative, Market Neutral, Nontraditional Bond, Multicurrency, Bear Market. Managers of liquid alt funds ranged from specialist boutiques to retail versions of established hedge fund managers. Growth in AUM in liquid alt mutual funds has since tapered off possibly because the liquid alt exposure is becoming more readily available – to institutional and retail investors alike – through Exchange Traded Products (ETPs). Liquid Alts – delivered as ETPs The growth in Liquid Alts continues in the ETP space which has enabled rapid innovation in the breadth and depth of the range of strategies available. With TERs of 0.20% to 0.60% for ETPs, compared to TERs of approximately 2.00% for 40 Act funds, there is a compelling cost efficiency too. This is a key reason that institutional investors are looking at liquid alt ETPs as a lower cost alternative to hedge funds with a similar portfolio function, according to Jay Pelosky of J2ZAdvisory a New York-based global investment advisory firm. The number of liquid alt (including Smart Beta) index strategies available to fulfil the role of of providing differentiated returns to traditional asset classes is expanding rapidly on both sides of the pond:
While the range of products available is far greater in the US than in Europe at this stage there is potential for Europe to “leapfrog” and catch up in terms of innovation and development given the high level of research in alternative strategies from institutional investors, index providers and academia, according to Mr Giraud. Liquid Alts – delivered as Model Portfolios Retail investors are not limited to alternative mutual funds, or alternative ETPs. Liquid Alt strategies can be made available via managed accounts which are unconstrained by the parameters of the 1940 Act or individual ETP construction. One of the key enablers for this was the investment into platform technology by North American brokerages that made Model Portfolios readily manageable, according to Suzanne Alexander of Cougar Global Investments, a tactical ETF global investment strategist focusing on portfolio construction with downside risk management. So whether as an investment strategy in itself, or an alternative part of traditional strategy, liquid alternatives are helping to redefine portfolio construction. In this respect, Europe is lagging with platform providers slow to offer ETFs, let alone ETF Model Portfolios (“EMPs"), according to Giraud. UK Platforms – ETF Ready? In the UK, platform providers remain focused on mutual funds as a way of delivering investment allocation to clients, and the bulk of investment research is skewed to fund manager research, rather than ETF research. Novia Financial is one of the few platforms to offer not only traditional fund services, but is actively seeking to improve adviser access to ETFs, through technology upgrades. Platforms that are “ETF enabled” can provide advisers the tools, products, and cost structure they need to compete on like for like terms with robo-advisers which typically use ETF Portfolios, aggregated trading, and fractional dealing to deliver low-cost scalable investment solutions. With this technological parity, advisers can then differentiate themselves on the core services that robos can’t offer: financial planning/wealth structuring (typically more material than investment allocation), face to face support and a relationship based on trust. Broadening the portfolio construction toolkit Retail investors continue to seek ways to diversify their portfolios. Institutional investors are losing patience with Hedge Funds’ lack of “value for quality” evidenced by the material redemptions from hedge funds (some $14.3bn net outflows in 1q16 alone, according to Preqin). This means there is growing demand for liquid alts both from the top down and the bottom up, according to Pelosky. Funds formerly allocated to hedge funds will have to find a home, and a reinvigorated lower cost liquid alt ETP sector could be in the running to capture part of it. Notes: Participants in the panel discussion on this topic included: Henry Cobbe, Elston Consulting (moderator) Susanne Alexander, Cougar Global Investments Jean-René Giraud, Trackinsight Jay Pelosky, J2Z Advisory NOTICES: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. This article has been written for a US and UK audience. Tickers are shown for corresponding and/or similar ETFs prefixed by the relevant exchange code, e.g. “NYSEARCA:” (NYSE Arca Exchange) for US readers; “LON:” (London Stock Exchange) for UK readers. For research purposes/market commentary only, does not constitute an investment recommendation or advice. For more information see www.elstonconsulting.co.uk Image credit: Elston Consulting. Chart credit: Spouting Rock
A survey published this week of 250 institutional asset owners with AUM in excess of USD2 trillion suggests that there is continued growth of interest in reviewing Smart Beta strategies. The survey is published by FTSE Russell and is available here. It suggests that 36% of institutional asset owners are currently evaluating smart beta, up from 15% in 2014. This implies the potential for large inflows into smart beta strategies over the coming 12-24 months. What is smart beta? From an index construction perspective, if beta is defined as index-based investment strategy constructed using a cap-weighted approach (size factor), smart beta can be defined as an index-based investment strategy using an alternatively weighted approach (any factor other than size). From a portfolio construction perspective, smart beta can be defined as an asset allocation strategy constructed using different optimisation techniques to combine a range of index-based investment strategies. What the factor? Risk and return can be broken down into many contributing factors. Analysing factors requires the ability to statistically distil, isolate, and observe a factor for significance. There are therefore potentially thousands of factors, depending on your ability to analyse them, which could include aside from the obvious (size and volatility), quality, momentum, value, liquidity, profits, dividend yield, leverage, etc which make up the components of earnings and/or the cost of capital which classically define a company’s value. The broadening and deepening of data availability and accelerating computing power is facilitating the growth in this quantitative approach. How do factors help? Buying the (cap-weighted) index for an asset-class (e.g. S&P 500 NYSEARCA:SPY, NYSEARCA:IVV (US); LON:CSPX (UK)) could be seen as a straightforward “passive” approach. Through a factor lense, however, it looks like a blind overweight of a size factor. Size factor may outperform in some market conditions and underperform in others. So while asset owners traditionally thought of asset allocation in terms of geographies and asset classes, they are starting to consider portfolio analysis and construction from a factor perspective. It’s no secret that sovereign wealth funds have been early adopters of smart beta investing: the transparency of a rules-based approach is additionally attractive. Is “smartie” the new “hedgie”? Like the original attraction of hedge fund, return enhancement and risk reduction are the primary motivations for reviewing Smart Beta strategies, according to the FTSE Russell report. Unlike hedge funds, cost savings are an attraction too. Sounds familiar? One of the original motivations for including hedge funds in a portfolio was for return enhancement and portfolio risk reduction through the inclusion of an uncorrelated asset. This ostensibly required exceptional skill, and hence exceptionally high fees. But the mantra supported the exponential growth in hedge funds from niche to mainstream from the early 2000s. Arguably, smart beta strategies can serve the same purpose from a portfolio construction perspective, but using a systematic rules-based approach that replaces manager risk (unpredictable, rarely consistent), with model risk (predictable, consistent). Combined with ego-free fees, it’s no wonder that there is so much interest in this investment approach. Flexible delivery? Furthermore, unlike hedge funds, smart beta strategies can be delivered to in-house managers, segregated accounts,– the equivalent of being able to “enjoy in your own home” – as well as ETPs and CITs (Collective Investment Trusts). Relative to hedge funds, this creates greater transparency about the counterparty risk you are taking. Has the switch started already? As if on cue, two stories on the same day this week illustrate the point. In the UK, some listed hedge funds are reported as losing two-thirds of their assets as performance disappoints and expensive alpha proves elusive. Separately, in the US there are reports of further M&A activity in the smart beta space with Hartford Funds, a $74bn asset manager acquiring Lattice Strategies, a San Francisco-based smart boutique with $215m AUM. This is the latest in a series of acquisitions by large asset managers of quantitative boutiques. What kind of smart beta equity strategies are available? Smart beta equity strategies for USA (NY-listed) and world markets (London-listed) include factor based strategies from BlackRock’s iShares® such as Quality (eg NYSEARCA:QUAL (US) & LON:IWQU (UK)), Value (eg NYSEARCA:VLUE (US) & LON:IWVL (UK)), Momentum (eg NYSEARCA:MTUM (US); LON:IWMO (UK)), and Size (eg NYSEARCA:SIZE (US); LON:IWSZ (UK)). What about multi-asset? Our approach has been to focus on risk-based portfolio construction which is why we launched our multi asset Global Max Sharpe Index (ticker ESBGMS) and multi-asset Global Min Volatility Index (ticker ESBGMV) back in December 2014. Our view is that smart beta is a new and powerful part of the portfolio construction toolkit. Conclusion We see smart beta as a diversifier for classically constructed portfolios and as a flexible tool for analysing and managing factor exposures at different stages of the market cycle. If the large institutional asset owners follow through their interest in smart beta with mandates, it will be an investment style that is impossible to ignore. NOTICES: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. This article has been written for a US and UK audience. Tickers are shown for corresponding and/or similar ETFs prefixed by the relevant exchange code, e.g. “NYSEARCA:” (NYSE Arca Exchange) for US readers; “LON:” (London Stock Exchange) for UK readers. For research purposes/market commentary only, does not constitute an investment recommendation or advice. For more information see www.elstonconsulting.co.uk Image credit: FTSE Russell "Asset allocation is not everything. It's the only thing."
One of the harshest lessons of the Global Financial Crisis was that when the going gets tough, correlations trend to one, giving even diversified investors very few places to hide. It wasn't about whether or not you got burned, it was a more a question of degree. While there's a time and a place for active stock selection, from a portfolio construction perspective, it's the active management of the overall asset allocation that affects the outcome. Using ETFs for portfolio construction The growing popularity in Exchange Traded Funds is in part because of their elegance in providing broad, liquid, efficient and cost-effective market access to most major asset classes with a single trade. We now have a broad range of building blocks with which to construct a diversified portfolio. As a result, the problem for investors has shifted from "How best can I access a broad choice of markets?", to "How do I create a portfolio that suits my needs?" How many ETFs are needed to create a portfolio? To create a portfolio with too few ETFs would mean there is limited scope to create different asset allocation strategies. To create a portfolio with too many ETFs introduces additional complexity, oversight requirements, and a higher degree of trading costs if the portfolio is to be regularly rebalanced. So what is the minimum number of ETFs needed to create a well-diversified portfolio? A Strategic Core For a strategic portfolio for a UK investor with £100,000 to invest and a desire to keep trading and ongoing costs to a minimum, we believe that advisers can construct strategic asset allocation models using the following “Magnificent Seven” broad asset classes alongside cash: UK Government Bonds, UK Corporate Bonds, Global Corporate Bonds, UK Property, UK Equities, Global Equities and Emerging Market Equities. All 7 of these asset classes can be accessed through BlackRock's iShares range, mostly from their cost-efficient Core range. Importantly, these ETFs are 'cash-based' or 'physical' meaning that they actually own the underlying holdings (unlike some ‘swap-based’ or ‘synthetic’ ETFs). Liquidity and diversification The fund sizes of these ETFs ranges from approx £400m to £4bn meaning external liquidity is high. Internal liquidity is as good as the underlying securities the ETF and index holds. While investors see only seven holdings, a portfolio containing these 7 large and liquid ETF building blocks represents a diversified portfolio of some 6,901 individual securities, all of which are fully disclosed for each fund. Strategic or Tactical After creating a strategic asset allocation model, ETFs mean that tactical asset allocation changes can be executed in real-time, which can give significant implementation advantage in these volatile times. As a starting point for advisers look to provide low-cost portfolio construction, using ETF building blocks for these key seven asset classes are a helpful first step. www.elstonconsulting.co.uk NOTICE This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of date of publication and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by Elston Consulting to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by Elston Consulting, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. ©2016 Elston Consulting Limited. All rights reserved. BirthStar, Elston Gamma, and Elston Strategic Beta are registered trademarks of Elston Consulting Limited. All other marks are the property of their respective owners. |
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