Liquid Alts 101, With Daniil Shapiro

With the rise of the alternatives industry and illiquid alts, liquid alts and alternative ETFs have grown apace. But which type of alternative offers better value to the investor?

Daniil Shapiro, director of product development at Cerulli Associates, returns to the show to discuss liquids alts and alternative ETFs, and how these compare to illiquid alts and intermittent liquidity products.

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Episode Highlights

  • An introduction to Cerulli Associates, and Daniil’s unique areas of coverage.
  • Concise definitions of the terms “alternative investment” and “liquid alts” (with some surprisingly subtle nuances).
  • A breakdown of the relative size of the major liquid alts markets (including mutual funds and exchange-traded funds).
  • The difference between an ETN and an ETF.
  • A window into the ETF industry, including which alternative ETF sectors were “darlings” in the past twelve months.
  • A sneak preview of Cerulli Associates upcoming white papers (including one that will be of particular interest to alternative investment issuers).

Today’s Guest: Daniil Shapiro, Cerulli Associates

About The Alternative Investment Podcast

The Alternative Investment Podcast is a leading voice in the alternatives industry, covering private equity, venture capital, and real estate. Host Andy Hagans interviews asset managers, family offices, and industry thought leaders, as they discuss the most effective strategies to grow generational wealth.

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Show Transcript

Andy: Welcome to “The Alternative Investment Podcast.” I am your host, Andy Hagans, and pretty exciting stuff today, we are kicking off a mini-series on liquid alts. So, typically on the show, we cover, can I use the phrase traditional alternative investments, illiquid alternative investments. But, you know, really more and more there is this blending, I guess, between the two worlds of alternatives, liquid alts, intermittent liquidity. It’s just something we need to dive into. We can’t put it off any longer. So, I’m very excited to announce that joining me today is Daniil Shapiro of Cerulli Associates. And Daniil, this is your second time on the show. The first episode we did was amazing, so I’m really excited to have you back on.

Daniil: Andy, thank you for having me on the show again, terrific to be here. Really glad to educate your audience on the liquid alternatives landscape.

Andy: And I think, you know, we have several ETF issuers scheduled to appear in the next few weeks. So, everybody, stay tuned for those. But I think, Daniil, you’re the perfect guy to kind of kick us off just because you cover this stuff, you kind of see the whole universe and you bring, can I say, an objective perspective to it. So, it’s been a little bit since you’ve been on the show, could you give us a brief introduction to Cerulli Associates and your role there, what you cover?

Daniil: Yeah, Cerulli Associates is a Boston-based research and consulting firm, and we’re focused exclusively on the asset and wealth management industries. We’re well known amongst advisors for the surveys that we administer and we survey hundreds of executives every year in terms of their specific functions. And that helps us build this really interesting product supply and product demand picture as well as understand some of the most important industry trends and provide that education back to the folks that we work with. In recent years, we’ve been very focused on the story of the build-out of the alternative investments landscape.

You have alternative managers, you have traditional managers, they are all looking to build these alternative products and target private wealth segments with those exposures. And I would say that the liquid alternatives are maybe the original alt products when it comes to retail channels and they’re doing great, you have over $1.1 trillion in the landscape. And of course, I think in this discussion, we’ll compare those products to those illiquid alts that you see…or other intermittent liquidity alts that are being driven down toward private wealth channels. My role at Cerulli Associates, I’m focused on both ETFs and alternative investments. So, I’m really happy to share insights for both of those today.

Andy: Yeah, I mean, that’s perfect, right? I think that’s what we’re talking about because as I said, on “The Alternative Investment Podcast, we’ve traditionally covered that world of illiquid alts, you know, kind of in that wheelhouse for family offices and for IRAs and wealth managers who advise high net worth clients. As you say, liquid alts, ETFs, those are truly reaching, you know, the mass retail market, although it has to be said a lot of IRAs, a lot of family offices, a lot of high net worth investors owned alternative ETFs, owned liquid alts. So, these different, you know, wrappers, they’re all kind of overlapping. But what we really want to cover today is Liquid Alts 101, I think, and just kind of getting kind of an introduction to the landscape and defining some of these categories. So, even before we define liquid alts, Daniil, what’s your definition of an alternative investment? What’s your definition of an alt?

Daniil: Yeah, and what we do at Cerulli is argue over this definition for very long periods of time. So, this is not anything that is not controversial but if I had to really define it, I would say it’s anything where the underlying exposure is not just a typical stock or a bond for the purposes of that discussion, even though these liquid alternative products may well be holding typical stocks or bonds, and that’s where it gets really confusing. But beyond the definition, we group commodities and alternatives together. We also place the entire non-traditional bond category into the alternatives bucket. And that’s just because when you have these large non-traditional bond funds, they have the ability to take duration to zero or even negative, so that means you’re not…it means that the value of the fund doesn’t drop just like a typical bond would when rates go up.

So, we consider that an alternative. Publicly listed REITs, REIT funds, we grouped that as an alternative, so that will become a very large alternatives bucket for us. And our argument for this has been you can buy an office building through a non-traditional REIT or you can buy it through a completely liquid limited partnership. But if you have a mutual fund which owns equity in a REIT which manages office buildings, then you are getting an alternative exposure. It’s almost the same…it’s the same underlying exposure across different structures, so we want to treat it the same way.

Andy: Yeah, it gets complicated in some of these little nooks and crannies and I think you kind of alluded to it. But another confusing thing…and my definition, I think, very similar to yours. My definition is really anything outside of the traditional stocks, bonds, or cash and cash-like instruments. To me, that’s an alt. But some of these alts that we’re going to talk about are holding, you know, traditional investments with alternative strategies. And so, I think maybe you alluded to that talking about these non-traditional bond, ETFs, or, you know, some of these fixed-income products. It’s also like a long/short equity fund, you know, like a hedge fund, you wouldn’t call that a traditional investment even though the underlying investments in the hedge fund are all, you know, in the equities market or relate to the equities market.

Daniil: Exactly, and this is where this definition becomes very, very convoluted and this is where there’s a lot of discussion taking place in the industry.

Andy: So, okay, an illiquid alt, let me define that. An illiquid alt, that’s an alternative investment that is not highly liquid. Okay? So, you can’t just go…if you decide, “I want to sell this investment today,” I can’t go sell it between now and the market close. If I own shares in a private placement offering or a non-traded REIT, there may be limited liquidity, there may be a secondary market. Sometimes there isn’t, by the way, sometimes there’s no…sometimes you’re locked in for literally a decade or longer. So, in this world of real estate, private placement offerings mostly talking about illiquid alts. Daniil, what is a liquid alt? Is there an official definition for that?

Daniil: Yeah, our definition for an illiquid alternative product will be something where the investor can receive their money back either throughout the day if that’s an exchange-traded fund, or at the end of the day if that’s a closed-end…excuse me, or at the end of the day if that’s a mutual fund. And a closed-end fund, you can also trade that intraday, so that’s another way to access some kind of alternative exposure and the ability to receive your money back the same day. I want to present this concept of liquidity spectrum. So, you mentioned that if you are investing in alternatives through a limited partnership, for example, that’s going to be completely illiquid. And then you have this wave of products that we spoke about during our last conversation that’s non-traded REITs, non-traded BDCs, interval funds. So, that’s where maybe you can access some of your money at the end of the quarter and we call those intermittent liquidity products. And then these ETFs, mutual funds, closed-end funds, these are the liquid alternatives and these are the ones that have daily liquidity.

Andy: So, I guess by default, we have then three broad classifications in our taxonomy of alts. We have traditional illiquid alts or just illiquid alts, we have liquid alts, and then somewhere in the middle is these intermittent liquidity products. Do you kind of…are those their own thing? Or do you kind of view those as adjacent to liquid alts?

Daniil: No, I think they are in their own category because they will hold…it depends on the product but sometimes you will have these intermittent liquidity products hold a mix of both underlying exposures that can be liquidated throughout the day but sometimes they’ll also own products that can’t be liquidated quickly at all. So, you can have intermittent liquidity products that own buildings, infrastructure, assets. So, to that degree, they are in their own pool.

Andy: So, depending on whether we’re talking about a liquid alt or intermittent liquidity product or an illiquid alt, sometimes the underlying assets will be accessible in any of those three types of alts. But then in other cases, the underlying asset may be specific to the category. Is that right?

Daniil: Exactly. It really depends. It depends on the structure that you’re using, it depends on what the underlying asset is, it depends on how the underlying assets are grouped. So, theoretically, yes, you can own a building through a liquid alternative product but it would have to be done through an underlying equity exposure and it wouldn’t be diversified, for example, with the aid of a manager that an intermittent liquidity product or an illiquid alt would be able to give you access to.

Andy: Okay. And so, just back to the initial deck, I love that you say at work, you guys argue about this all day. Actually, that makes me feel better because I literally host “The Alternative Investment Podcast” and you asked me what an alt is and I’m like, “Well, I can’t really answer that question.” So, it makes me feel a lot better, Daniil, I’ll have to say. But to me, liquid alt is almost an oxymoron because I associate exchanges and liquidity with traditional investment products, not non-traditional. So, you know, liquid alt, does that entire concept an oxymoron?

Daniil: Yes and no. If you look under the hood of a lot of liquid alternative products, you will find these very traditional securities that are not in any sense alternative investments. At the same time, they are also very different from what you receive through an illiquid alternative product. When I think about purchasing an illiquid alternative and I’m thinking about…let’s call it a private equity fund, I’m looking to access the best possible manager who’s going to make the best, let’s call it, buyout decisions, they’re going to do due diligence, and they’re going to select deal flow that is going to be really important to them.

And hopefully, they can find the best companies to buy, and then they’re going to make operational improvements in those companies in order to add value that way. That’s what you’re buying when you’re buying a private equity fund. And when we look at replicating this to a liquid alternative structure, there isn’t really a way to do that. You can’t access the same skill of that manager. And the same thing happens on the hedge fund side when you look at the types of hedge funds that investors want to access: Millennium, Two Sigma, Citadel. They are using strategies that really aren’t available in the mutual fund and ETF structures, so they’re doing something very, very different.

Andy: And to pause there, why is that? Is that because their strategy is not implementable if you have the constraint of daily liquidity? Is that essentially the reason, or…?

Daniil: That’s certainly a really important consideration. It’s about the managers that are offering products in each, so the managers themselves are different. Some of those venerable hedge fund managers have not necessarily shifted into the liquid alternative landscape, even though liquid alternative landscape does have a stable of very high-quality managers that are just doing many different things, they’re looking at arbitrage in different anomalies. But to your point, there are certain things that you can do in an illiquid hedge fund, which doesn’t have to return customers’ money at the end of the day or even at the end of a quarter, and the things that you can do in a daily liquidity structure, they’re very different. You have the ’40 Act, which subjects them to different leverage and concentration requirements and liquidity requirements. So, all those things together mean that you can’t have the same type of exposure across the different structures.

Andy: Okay. Yeah, that makes sense. Well, in our previous episode, I mean, we covered a lot of these traditional alts. We also talked about intermittent liquidity products and I guess we save the liquid alts for today. So, why don’t we start there? So, now we’ve kind of defined the landscape as much as we can. Okay, next, I’m going to ask you, by the way, how many angels can dance on the head of a pin. But I want to talk about wrappers, right? Because with illiquid alts…you know, we talked about non-traded BDCs, non-traded REITs, DSTs. I mean, so much is wrapper-specific in that world. What are the major wrappers in terms of liquid alts? What are the major product types independent of strategy?

Daniil: So, I have some stats that I’d love to quote here. If we take the U.S. liquid alternative industry…and we have these numbers as of 1Q 2022 but they are very, very indicative. Out of $1.1 trillion in U.S. liquid alternative assets, about slightly more than half of that will be in the mutual fund structure. And the mutual fund structure, there’s a long history going back here in terms of these products in the mutual fund structure. I would say that at the middle of the last decade, there are probably too many liquid alternative funds and the story was a little bit oversold and there was a lot of rationalization. So, a lot of these products, some of them closed over time, assets have somewhat went out, but this category certainly did throughout the last few years and has somewhat rebuilt itself.

Andy: And when you say mutual funds, just to confirm, that includes actively managed mutual funds, does that also include index funds as a type of mutual fund?

Daniil: At the definition, yes, it does. So, slightly more than half of that 1.1 trillion will be mutual funds, and then you have exchange-traded funds, and exchange-traded funds will be slightly less than half of that exposure. And then the remainder, there’s a small sleeve, and that’s going to go to the closed-end funds. There is a difference between the types of strategies that are available in the mutual fund structure and the types of strategies that are available in the ETF structure. The ETF structure really tilts toward an index product, it tilts towards commodities products, and kind of based on the definition laid out earlier, a lot of the ETF assets are in those low-cost real estate trust funds.

So, this is going to be Vanguard-VND, for example. We absolutely classify that as an alternative exposure and that’s gonna be one of the larger alternative liquid alt products. The same thing for those commodities ETFs, GLD, IAU. So, that’s kind of…that’s how they differ. And then I would argue that mutual fund structure really does have more of the liquid alt type. When investors think alternatives, they’re probably thinking more toward those mutual fund-type strategies.

Andy: Interesting. Yeah, so as you point out, the mutual fund liquid alt space, a little bit larger, and the ETF liquid alt space, a little bit smaller. But if we’re kind of skating to where the puck is going, you know, and thinking, you know, where are we going to be 10 years from now, alternative ETFs, are they going to be the big kid on the block?

Daniil: I believe so, yeah. I think that just because they tend to be less expensive and they tend to be those simpler type exposures…and we could talk about that throughout this conversation, investors love simplicity. They love these buffer products, which maybe give them the types of exposures they understand, they offer some risk mitigation, they offer upside participation. So, just because these exposures are low cost and they are easier to understand, you will see that continued gravitation toward the ETF structure, even though you will continue to see those mutual fund managers also do quite well on those liquid alternative products.

Andy: Interesting. Yeah, it’s interesting for me to…you know, I’ve sort of seen the ETF space change a little bit. I’ve been covering it more closely, or I guess at a distance for really about 15 years now. And I think you’re totally right, ETF investors are, like, trained to look for, you know, tracking an index, extremely low costs, everything gets compared to a Vanguard ETF with, you know, a five-basis point expense ratio. But I will say, especially in the past few years, I’m starting to see more actively managed ETFs amass assets, you know, and actually be economically viable working for the issuer. From the standpoint of the issuer, you know, profitable product, and from the standpoint of the investor, you know, a popular product. So, I’m seeing more actively managed ETFs, some of them have higher expense ratios.

You know, like in the hedge fund replication space with hedge fund ETFs, they’re kind of a different animal. And the interesting thing to me…and by the way, we’re gonna have some hedge fund ETF issuers on in this mini-series, so I’m really excited for that. But the interesting thing to me is, you know, I remember when hedge fund ETFs first started launching and their investors at least on like the retail level, it was like, “These expense ratios are too high, this is an ETF, the expense ratio needs to be, you know, 10, 20, or maybe 30 basis point,” whatever.

And I think there’s just a little bit of a shift now where some investors are able to say, “Okay, this ETF may have an expense ratio that’s way higher than an ETF that tracks S&P 500, but it’s an actively managed fund with daily liquidity and I’m actually going to compare it to a hedge fund, I’m actually going to say, you know, more from in terms of the strategy that it’s following.” And the expense structure is actually way, way more efficient and actually low when I’m comparing this hedge strategy ETF with an actual hedge fund. Do you see more, I guess, acceptance with those kinds of ETFs?

Daniil: Andy, you’re bringing up an absolutely brilliant point. I think every investor when they are looking to access some kind of exposure, let’s call it real estate for the purposes of this example, they have to make this cost-benefit decision. They have to say to themselves, “Do I want to access the best real estate manager and pay them a fee of several percentage points and access it through an illiquid product or an intermittent liquidity product,” that can be one option, “or do I want to maybe buy it through a mutual fund, which will also have an actively…which can have an active strategy, but they’ll be looking to select these types of exposures from publicly listed securities and maybe they’re going to charge 100 to 150 basis points?”

But because there is that active approach, maybe it’s not as active as the liquid active approach, but they’re going to have an active manager sitting there and making these decisions that cost a little bit less. Or, of course, the third option is you pay, let’s call it 10 basis points for a REIT ETF, but then you know that there is not someone there that is making that active decision. And it is possible that you get a portfolio of are markets efficient, are markets inefficient discussion for a different podcast but you may well end up with a portfolio of securities that are just based on an index and there is not necessarily that active manager guidance or active decision-making that has gone into that selection of securities that you’re receiving for 10 basis points. So, you have to make that decision.

Andy: And, you know, I think that’s a brilliant way of putting it because, for me, it is product by product, manager by manager, sector by sector. I’m a big fan of indexing and passive strategies and low costs. And then there are other segments, sectors, asset classes where I really respect and see the value of active management and the price is not going to be comparable to an index fund but at the same time, it may justify itself, you know? So, for what it’s worth, my two cents is I take it product by product, niche by niche, sector by sector rather than make some, you know, big all-encompassing statement.

Because the truth is there are plenty of hedge funds with pretty high expense structures making an enormous amount of money for their investors who are very, very happy to be invested there, and obviously, there’s very many happy ETF investors. So, on that note, a technical question, when we’re talking about ETFs, are we folding the ETNs in there with ETFs? And actually, while we have you on the show, could you walk us through the difference between an ETN and an ETF? Can an ETN be a liquid alt?

Daniil: So, you can be an illiquid alt in the ETN structure.

Andy: Okay.

Daniil: You can be an illiquid alt in the ETN structure. The difference there is that unlike an ETF, ETFs actually own the underlying securities. When you buy an ETF, you buy an ownership stake in whatever the underlying security of that ETF is. Unlike that, the ETN is really a debt instrument that’s often issued by a bank. So, you’re not buying an underlying, you’re buying an unsecured debt obligation of the firm that is selling it to you. And to be fair, we’ve seen…we don’t spend as much time focusing on ETNs nowadays because we have seen a lot of managers step away from offering them.

And it’s both because it’s maybe a little bit more of a risky structure for both the investors who are buying them, but also those firms that are offering them because you have basis risk. So, there have been instances of hiccups taking place with those ETN products where the ETN stopped being able to track what it was supposed to track. On the other hand, I will caveat this with saying that if a certain exposure is very difficult to access through underlying securities, you maybe are better off in the ETN structure. So, there is some use case for them.

Andy: So, when we talk about ETFs like in those statistics or when we are colloquially talking about ETFs, are we kind of folding ETNs in with them or not? We’re making that distinction?

Daniil: Yeah, right, for us, ETNs are outside of the ETF landscape and they are a relatively small category of the overall market.

Andy: Got it. Yeah. Yeah, I remember, I mean, this was a decade or more ago, it was the big thing in gold ETFs, right? You had some gold ETFs that were holding the physical bullion in a vault somewhere, whereas others were tracking an index of the price of gold, but not actually holding physical gold. So, some of these, they might seem, you know, esoteric, but if you’re a gold bug, you know, that’s actually really important and you’re like, “No, I want to make sure that I own my share of physical gold being stored in a vault in Switzerland or London somewhere.” So, we’re talking about ETFs, I already mentioned gold ETFs, I gotta say those are a little boring. Like, I did that deep dive like a decade ago. But you mentioned already these kinds of two supersectors in the alternative ETF sector: REIT ETFs and commodity ETFs. Let’s dive into those landscapes a little bit. Let’s start with REIT ETFs. You know, how’s it going in that space?

Daniil: They have been able to attract flows over time and this is driven by, yeah, the fact that the strategies are very attractively priced, they make for good data exposures, and they are attracting assets from investors.

Andy: Okay. Okay. And what about commodity ETFs? I mean, for ETFs, I feel like, you know, the commodity ETFs were kind of a game changer in a lot of ways, it’s just like a cheap and easy way for investors to access certain asset classes. What’s going on in that landscape right now?

Daniil: Commodities ETFs had modest outflows last year, this is nothing serious. So, they’re still gaining adoption. I think a lot of times they’re just being traded by investors, sometimes you have flows that do the opposite of what you would expect to happen. So, after you had the Russian invasion of Ukraine, you had flows into commodities ETFs and then those flows somewhat came back out. So, I don’t want to judge this entire category based on maybe flows this year, but over time, they have gathered attractive assets.

Andy: Are there any, you know, little sub-sectors, I guess, in that whole, you know, commodity REIT or really any alternative ETF space? Is there anything that’s really red-hot right now where we’re seeing, you know, lots of issuances or maybe even filings where you might see some more issuance later this year?

Daniil: Yeah, there have been some individual strategies that have absolutely knocked it out of the ballpark. The ones that I’m thinking about are JPMorgan Equity Premium Income, that’s a covered call product that offers, yeah, upside participation as well as some additional income. And that’s been a fund that has generated tremendous flows from investors and this is because income has been really, really difficult for investors to receive maybe until earlier this year. So, that’s been…

Andy: So, that ETF was kind of offering good income, good yield, when very few other ETFs were? And that kind of was the tailwind for that launch?

Daniil: Precisely, and that’s been a very attractive product for advisors. And you had that DBi Managed Futures Fund that did really well and that also gathered very significant flows last year, so that’s been a really interesting strategy. So, you have one of those strategies that do really well. We’ve also seen the build-out of those buffer ETF products. So, those have all worked really, really well. I think what we really haven’t seen…

Andy: Well, hold on, I actually want to hear more about the buffered ETFs because I think a lot of investors are interested in the…even retail investors might be interested in these. So, what’s the idea behind the buffered ETFs?

Daniil: With buffered ETFs, they’re offering…they’re holding options inside the ETF. So, what they do is they provide you with a payout pattern that is supposed to, to some degree, match…they’re able to provide you with some payoff profiles for the product. So, when you’re buying it, you know what to expect, you get some downside protection and at the same time, you receive some upside participation, they’re likely capped at some point. A key challenge with the products is they’re not paying dividends, there’s still some kind of…there’s still an expense ratio that’s associated with them. So, while they are very attractive from that kind of risk management perspective, the challenge there is that, like anything else in investment markets, you have to give something up in order to receive something else. So, there is that…there is some downside that’s associated with them.

Andy: So, that almost sounds to me like a structured note almost, packaged for a retail investor in an ETF, is that…?

Daniil: Yeah, it’s interesting that you say that, we almost looked at these almost as, yes, structured notes, but also kind of maybe a variable annuity.

Andy: And those, by the way…so, here’s the interesting thing, there’s downsides to the buffered ETFs as you point out. So, like these variable annuity products, you know, some retirees like them because they give you guaranteed payouts so you get the downside protection, but then if the S&P goes on an incredible run, you get some upside participation as well but they have very high fees. So, it’s like almost anywhere you go in that kind of world of buffering, it seems like there’s high fees associated with them. Okay, there’s been some momentum in buffered ETFs, that JPMorgan ETF that you reference. Excuse me, the managed futures ETF, a little sneak peek, we’re going to be having DBi on the podcast here in a couple of episodes. So, stay tuned for that because we’re going to talk a lot about managed futures. Anything else in the ETF space, alternative strategies that are hot right now?

Daniil: There are also a lot of…in the ETF space specifically, you have a lot of one-off products that do well for particular periods of time. So, that’s certainly taking place, you have a number of attractive products there. I’m thinking about at a category level, it’s a little bit difficult to spot trends there because again, everything kind of varies based on the market environment and we don’t want to draw too much of a conclusion from a shorter period of time. I think it’s that kind of…it’s those derivatives income products that have done really well.

That’s going to be like JEPI, QYLD, these are covered call type strategies and, yeah, I think…and then the buffered funds that are also under the options trading category. Those are probably the ones that are doing the best right now. And then you have…when we’re looking at more of the hedge fund-type strategies that’s kind of multi-strategy and others, you’re going to have individual funds that do well there but it’s kind of…it’s more difficult to spot sustainable growth there.

Andy: That’s more, you know, if you have 10 hedge funds following 10 different strategies, there’s always going to be one or two that outperform in any given year. Is that kind of what I’m hearing if I read between the lines?

Daniil: That’s precisely it. And to be fair, a lot of liquid alternatives is like this. So, you have some strategies that are very complex and they’re doing well for particular periods of time, so you have to really look under the hood. And it’s really tough to pick winners and we certainly don’t want to take a look at, you know, two, three years of performance and say, “Look, this category is the future,” and the next thing you know, the market environment changes slightly and suddenly, the performance is completely different. And that, by the way, is what has happened with a lot of liquid alternatives products over time, which is why advisors need to do their due diligence and understand what they’re buying.

Andy: Well, that brings to mind managed futures, right? Which was a strategy that has been identified as a good strategy during periods of market drawdowns or certain time periods. And the strategy didn’t necessarily, you know, perform that great but then, last year, just had an incredible…managed futures had an incredible year, kind of lived up to the hype. And so, I think for some of these products, especially alternative strategies, like not just these alternative asset classes but the alternative strategies, in my view, you really need that whole market cycle or even multiple market cycles, you need 5 to 10 years of performance data to where you can really zoom out and say, “Did this product live up to the hype? Did it, you know, fulfill its stated objective?” And I think the challenge for boutique ETF issuers is, you know, can you sustain the ETF for that full market cycle to kind of let that ETF prove out its story? Do you see that? Is that a trend with the smaller ETF? I mean, I love boutique ETF issuers because there’s so much creativity in that space, is it a challenge for them to be economically sustainable?

Daniil: I think the answer is yes, it is. But at the same time, I would say a lot of times, you have these ETF issuers that are smaller shops that are bringing really unique product to market and they’re bringing in things that are really, really interesting, and maybe things that some of the larger ETF issuers are just not willing to do. Maybe because it’s a little bit risky, maybe because it requires a lot more consensus to launch. So, you have…kind of to your point, they’re very often very, very creative, they’re doing something niche and new, it’s more of an exciting product. And a lot of times, you know, it’s difficult to select which of these strategies will work and it’s difficult to do across the entire liquid alternative spectrum, it’s difficult across the entire product spectrum.

But sometimes you will see these products really take off because they are able to identify either an anomaly or some really interesting trend before it really takes off. And at those times, you have an investor that’s really on the ground floor of a really big trend. So, that’s a very exciting thing. Just to be clear here, this still means you have to do a lot of due diligence on these products, you have to know what you’re buying, you have to know what that strategy is investing in, you have to do a lot of thinking there.

Andy: Yep, I mean, outside of SPY, I think you have to do due diligence on…and maybe even that one, you know, I don’t know. You know, I’m not asking for any specific data here, but in terms of advisors, you know, what’s the sense you get for IRAs, wealth managers, between private equity, intermittent liquidity, and liquid alts? Is there one broad liquidity preference or type of alternative exposures? Is it advisor by advisor kind of has a preference, or even client by client?

Daniil: It’s going to be advisor by advisor. And because you can’t access the same exposure across multiple structures because the management styles are different, etc., that really drives this difference. So, you will have advisors that say, “We want to access alternatives,” and they recognize that the specific type of alt that they’re thinking about is only accessible through an illiquid or an intermittent liquidity product, so they have to go that route. I think there are a couple of broad guidelines here. More liquidity is better, providing that your product allows for it. So, advisors love liquidity and you want to be able to get a client’s money back, right? Clients don’t need their funds until a specific date when they need access to them in order to buy a boat. So, that’s all very, very important.

Andy: Or a Porsche, you know? Come on, let’s not limit ourselves to boats, Daniil.

Daniil: Yes, there you go. We have to…yes, you want the best thing possible. But yeah, the problem there is that you can’t offer specific strategies for the maximum amount of liquidity, you can’t offer a manager skill set and offer full liquidity at the same time for certain types of strategies, so it all gets in the way. I think other trends in terms of advisor use, a lot of advisors are not using alternatives. So, that’s something that we know, and they’re not doing this because alternatives can be complex, but they can also be unsuitable to their clients. And then liquid alts…

Andy: Wait, wait, sorry, sorry, just hold on to that. I mean, I’m aware that there’s a lot of advisors who still aren’t really in these illiquid alts, maybe even aren’t using intermittent liquidity products. But you’re telling me that there’s IRAs in 2023 that aren’t even using any alternative ETFs in client portfolios?

Daniil: I would say very likely.

Andy: Wow.

Daniil: There very likely is a portion that are not doing that, they do not think that it’s within their mandate to, for example, buy even a gold ETF, right?

Andy: I was gonna say GLD, I mean…wow. Okay, so there’s still…I mean, we know that there’s limited adoption but I mean, I feel like the most traditional edge of this liquid alt space is just so adjacent to your traditional asset class that you can just take a 60/40 portfolio and just throw in 2% exposure to GLD or to commodities, right?

Daniil: Well, that’s the thing and it sounds like such an obvious thing to do, but GLD doesn’t provide income.

Andy: Okay, fair.

Daniil: Yeah, there are drawbacks. There are drawbacks to a lot of these routes.

Andy: Fair enough. Okay. So, let’s zoom back out then and talk about, you know, big picture. Because I know…and you’ve already kind of alluded to this and it depends on the strategy, it depends on the manager, the asset class, etc. But when we compare liquid alts to traditional illiquid alternative investments…and let’s put intermittent liquidity aside for now, let’s kind of compare the extremes. Where do liquid alts have the advantage over illiquid alternatives?

Daniil: I think that the advantage is going to come from the fact that you can get your money today, that you can have your money back today. You’re not going to run into a gate on the product, you’re not going to be asked to wait for a quarter or a year or five years. If you want your money back, you can have it back. So, that’s the first great thing with liquid alts. The second one is that you’re probably going to get a slightly more attractive expense ratio, it’s going to likely cost less than that same exposure on the illiquid side. So, from that perspective, you have two big advantages there.

The third one there is probably around due diligence. Because you have illiquid alternative products that fall within the remit of the ’40 Act, you’re going to have more investor protections. Let me just be clear, you have to do a lot of due diligence, you have to understand what the strategy is holding, how it’s implemented, etc. Due diligence is key, we need to remind that, we need to remind everyone about that, I think we as a society need to remember the fact that due diligence is really important. You still have to do that, but maybe you need to…maybe it’s a little bit of a simpler process than you would go through when accessing liquid alternative process…or liquid alternative exposure. So, those are some really key differences there.

Andy: Yeah, and, you know, you mentioned typically lower expense ratio with illiquid alt, is that because…I guess to keep it apples to apples, is that because active management is less expensive for illiquid alt just because most liquid alts happen to be following an index?

Daniil: I would say…let’s assume that we aren’t comparing active strategies within both structures across both liquidity types. Yeah, picking stocks and bonds is certainly cost intensive but it’s not as cost-intensive as underwriting debt or buying out a company because you have to do due diligence in those cases and that costs tremendous sums of money in order to evaluate exposure, so you have highly paid professionals on both sides, but getting into illiquid space is probably a little bit more intensive. So, I would argue that costs are going to be higher on the illiquid side.

Andy: Okay. So then, those are the advantages of liquid alts and it’s obviously starting with liquidity. And then when we’re talking ETFs, I don’t care what, you know, niche that you’re in in the ETF space, there’s always that downward cost pressure, at least that’s my impression. I’m not an ETF issuer but that’s the impression I get just from, you know, media coverage and just talking with other investors, talking with IRAs. But what about the drawbacks of liquid alts? Are there areas where these traditional illiquid alternative investments have an edge compared to liquid alts?

Daniil: And this is kind of, yeah, the reverse side of what we just discussed. You don’t have…you’re going to be operating in segments where a manager may not be able to deliver their full value add. So, you’re not accessing the management team of a venerable private equity manager in order to help you make those investment decisions. You’re not going to be buying, for example, when we’re thinking about some of…when we’re thinking about real estate, you’re not going to have a team that’s able to buy a bridge or buy a building in a particular location or get warehouse assets, etc. You’re not going to be able to do that through the ETF or the mutual fund structures. They may still buy underlying publicly traded securities but they may not be able to do…they may not be able to enact the same strategy as they would be able to enact on the illiquid side.

And I think private credit is an excellent example of this. If you think about Elliott Capital Management and what they went through with Argentine debt and how at one point, there was an instance where they commandeered an Argentine ship, this is not…that is a strategy that a hedge fund can take upon themselves. A hedge fund can hold debt through a restructuring, etc., and you just can’t do the same thing on the liquid alternative side because you have to trade liquid securities and you can’t commandeer ships. So, you have two very different things that you can do on both sides. So, there’s probably…there’s this argument that can be made on the liquid alternative side that on the liquid alternative side, the strategies are, to some degree, a little bit watered down but this brings us to our earlier point as to whether you accept that trade-off.

Andy: Yeah, I mean, so you mentioned certain strategies can really only be implemented in an illiquid investment vehicle. And, you know, you mentioned private credit, certain private equity strategies, obviously, all kinds of real estate strategies are best, you know, contained within that illiquid wrapper. And then I think hedge funds are super interesting. Maybe we don’t need to go quite down that rabbit hole but hedge fund is just a word that can mean so many different things, it can encompass so many different strategies. And there are certain strategies…and this is a little sneak preview coming up in the mini-series, but there’s certain strategies that ETFs can replicate or can attempt to replicate in the hedge fund world but there are other hedge fund strategies that are simply not possible, you know, with illiquid ETF. So, you know, in some cases, they’re not really competing, right? In some cases, there’s illiquid alts and there’s really no liquid alt alternatives, is that right?

Daniil: That’s exactly the case. Yeah, different exposures and different structures.

Andy: So, Daniil, this has been awesome, I mean, you know, because we talk about alts, we talk about liquid alts, intermittent liquidity products. I love going back to the basics and just trying to define all the stuff but it’s also really humbling because as…I mean, I fall into traps myself trying to define these things and it’s not so easy. It sounds like you and your team at Cerulli Associates, you’ve put a lot of thought into this and I really appreciate, you know, you coming on and sharing your insights and sharing your thoughts because I think that’s almost step one. Before we can analyze and before we compare these investments, we have to sort of know how to categorize them, how to find comps, you know, how to compare them. So, I can’t thank you enough for, you know, coming on the show again, sharing your insights. And that being said, where can our listeners and viewers go to learn more about your research and to learn more about Cerulli Associates?

Daniil:, and also look for us on LinkedIn, you can follow our Cerulli Associates page and you’ll see all the updates. We’re consistently publishing different white papers. We are very focused on the alternative story. We have white papers on advisor use of alternatives and you will see more of those in the future. So, a lot of research there.

Andy: What’s the next white paper that’s coming up, Daniil? Anything good?

Daniil: We are about to publish a white paper on how U.S. alternative investment managers are choosing international domiciles as they try to raise capital overseas. So, how do you decide between domicile, like, in Luxembourg versus Jersey, Guernsey, or another location?

Andy: I don’t even know where Guernsey is but I’m interested. So, make sure to get on that LinkedIn page. And by the way, I’ll make sure to link to…I’m gonna link to our previous episode with Daniil because I think that provides more context and also link to Cerulli Associates, the website, and that LinkedIn page. Daniil, thanks so much for coming on the show today.

Daniil: Andy, thank you for having me on the show.

Andy Hagans
Andy Hagans

Andy is a co-founder of WealthChannel, which provides education to help investors achieve financial independence and a worry-free retirement.

He also hosts "WealthChannel With Andy Hagans," a podcast featuring deep dive interviews with the world’s top investing experts, reaching thousands of monthly listeners.

Andy graduated from the University of Notre Dame, and resides in Michigan with his wife and five children.