Using ETFs to access alternative asset classes

Henry Cobbe explains how investors can use ETFs to access alternative asset classes such as private equity, property and infrastructure.

This is the sixth in a series of articles by Henry Cobbe, head of research at Elston Consulting, exploring the world of index investing. Henry is author of  How to Invest With Exchange-Traded Funds.

Non-indexable asset classes

While equities, bonds and cash are readily indexable, there are exposures that will remain non-indexable because they are:

• Illiquid in nature (inaccessible markets, for example, infrastructure contracts, toll roads, power contracts, wind farms, aircraft leasing, railway operating contracts)
• Require or reward subjective management and skill (“true active”, for example, high-conviction long-only funds, or long/short hedge funds)
• Difficult to hold (commodities, for example)

On the face of it, alternative assets seem less suitable to indexing, for example, property, infrastructure, private equity and hedge funds.

However, it is possible to represent some of these alternative class exposures using liquid index proxies. Index providers and ETF issuers have worked on creating a growing number of indices for specific exposures in the liquid alternative asset space.

Some examples:

• For property as an asset class, exposure can be achieved via an index of listed property companies. This is a more liquid way to obtain exposure to the asset class than traditional property funds that own direct property, and means that there is less liquidity risk (as we saw in 2016 Brexit and 2020 Covid market dislocations) compared to traditional open-ended property funds. Unlike traditional funds, property ETFs did not experience suspensions or gatings
• For infrastructure, exposure can be achieved via an index of listed infrastructure equities, or a multi-asset infrastructure index that has both equities and bonds (reflecting infrastructure’s bond-like characteristics).
• For private equity, there are listed private equity firms that benefit from returns in that sector
• For commodities, exposure can be achieved via a diversified basket of commodities held via an exchange traded product (ETP) that tracks a broad commodity index
• For gold, exposure can be through gold producers, synthetic exposure to gold, or to a physical fund that tracks the gold price whose underlying holding is gold bullion.

These liquid index proxies for alternative assets have broadened the range of asset classes investable via ETPs.

Fig.1. Example of ETPs accessing liquid alternative asset classes

Source: Elston research. Note: ETP stands for Exchange Traded Product.  Sub-sets of ETPs include both Exchange Traded Funds (ETFs), Exchange Traded Notes (ETNs) and Exchange Traded Commodities (ETCs).

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Alternative asset index proxies

While these liquid proxies for those asset classes are helpful from a diversification perspective, it is important to note that they necessarily do not share all the same investment features and, therefore, do not carry the same risks and rewards as the less liquid version of the asset classes they represent.

Fig.2. Comparing alternative assets to their ETF proxies

Source: Elston research, for illustration only

While ETFs for alternatives assets will not replicate holding the risk-return characteristics of that exposure directly, they provide a convenient form of accessing equities and/or bonds of companies that do have direct exposure to those characteristics.

Using investment trusts for non-index allocations

Ironically, the investment vehicle most suited for non-indexable investments is the oldest “exchange traded” collective investment there is: the investment company (also known as a closed-end fund or investment trust). The first UK exchange traded investment company was the Foreign & Colonial Investment Trust (LSE:FCIT), established in 1868.

Like ETFs, investment companies were originally established to bring the advantages of a pooled approach to the investor of “moderate means”.

Fig.3. Comparing structure of ETFs to investment trusts

Source: Elston research

For traditional fund exposures, for example, UK equities, global equities, our preference is for ETFs over actively managed investment trusts owing to the performance persistency issue that is prevalent for active (non-index) funds. Furthermore, investment trusts have the added complexity of internal leverage and the external performance leverage created by the share price’s premium/discount to NAV – a problem that can become more intense during periods of market stress.

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However, for accessing hard-to-reach asset classes, investment trusts are superior to open-ended funds, as they are less vulnerable to ad hoc subscriptions and withdrawals.

The Association of Investment Company’s sector categorisations gives an idea of the non-indexable asset classes available using investment trusts: these include hedge funds, venture capital trusts, forestry and timber, renewable energy, insurance and reinsurance strategies, private equity, direct property, infrastructure, and leasing.

A blended approach

Investors who want to construct portfolios accessing both indexable investments and non-indexable investments could consider constructing a portfolio with a core of lower-cost ETFs for indexable investments and a satellite of higher-cost specialist investment trusts providing access to their preferred non-indexable investments. For investors who like non-index investment strategies this hybrid approach may offer the best of both worlds.

Summary

Areas of the investment opportunity set that will remain non-indexable are those that are hard to replicate as illiquid in nature (hard-to-access markets, or parts of markets); and those that require or reward subjective management and skill.  Owing to the more illiquid nature of underlying non-indexable assets, these can be best accessed via a closed-ended investment trust that does not have the pressure of being an open-ended fund.

ETFs provide a convenient, diversified and cost-efficient way of accessing liquid alternative asset classes that are indexable and provide a proxy or exposure for that particular asset class. Examples include property securities, infrastructure equities & bonds, listed private equity, commodities and gold.