​Which asset classes are not indexable; what proxies do they have that can be indexed; and why it can make sense to blend ETFs and Investment Trusts for creating an allocation to alternative asset classes

​In this series of articles, I look at some of the key topics explored in my book “How to Invest With Exchange Traded Funds” that also underpin the portfolio design work Elston does for discretionary managers and financial advisers.
 
Non-indexable asset classes
Whilst Equities, Bonds and Cash are readily indexable, there are also 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 (for example commodities)

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

It is however 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 are set out below:

• 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 that asset class than traditional property funds that own direct property, and means 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 saw no 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 which benefit from returns in that sector.
• For commodities, exposure can be achieved via diversified basket of commodities held via an exchange traded product that tracks a broad commodity index
• For gold, exposure can be either to gold-producers, or 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.

​Alternative asset index proxies
Whilst 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.

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.
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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, established in 1868.
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Like ETFs, investment companies were originally established to bring the advantages of a pooled approach to the investor of “moderate means”.

For traditional fund exposures, e.g. 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 & Timber, Renewable Energy, Insurance & Reinsurance Strategies, Private Equity, Direct Property, Infrastructure, and Leasing.

A blended approach
Investors wanting 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 world.

Summary
The areas of the investment opportunity set that will remain non-indexable, are (in our view) 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.

• Gold has rallied +34% YTD in GBP terms
• The largest 3 physically-backed ETPs are those from iShares, Invesco and Wisdom Tree
• Costings range from 0.19% to 0.39% TER

 
We look at the three largest ETPs that track the gold price and which are “physically-backed” (meaning they own the underlying asset), and track the same spot price index, the LBMA Gold Price Index.
Each of these ETPs offers a London-listed share-class, and each also offers a GBP-denominated listing.  This means that the share price is expressed in GBP-terms.  This is convenient for client reporting and essential for some platforms.  The returns, however, remain unhedged to GBP.
Whilst SGLN and SGLP are Irish-domiciled funds, PHGP is Jersey domiciled.  Each has UK tax reporting status.
In terms of scale and cost, iShares Physical Gold ETC (Ticker: SGLN, launched in 2011) is the largest at £11.9bn with TER of 0.19%, followed by Invesco Physical Gold (Ticker: SGLP, launched in 2009) at £10.7bn with TER of 0.19%, followed by WisdomTree Physical Gold (Ticker: PHGP, launched in 2007) at £7.1bn
With increasing choice available, the key differentiation amongst physically-backed ETPs is cost.
Fig.1. YTD performance of largest London-listed Gold ETPs

Source: Bloomberg, as at 7th August 2020, GBP terms

​NOTICES
Commercial Interest: Elston Consulting Limited creates research portfolios and administers indices that may or may not be referenced in this article.  If referenced, this is clearly designated as such and is to raise awareness and provide purely factual information as regards these portfolios and/or indices.
Image Credit: Shutterstock

• We look at 2 sub-sectors of Liquid Alternative ETFs available to UK investors: Liquid Alternative Assets and Liquid Alternative Strategies
• Within Asset Classes, Gold has proven its defensive qualities in market turmoil
• Within Strategies, Market Neutral has proven most defensive

 
Liquid Alternatives: Assets
We define Liquid Alternative Asset ETFs as tradable ETFs that hold liquid securities that provide access to a particular “alternative” (non-equity, non-bond) asset class exposure.
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More specifically, we define this as Listed Property Securities, Infrastructure Securities, Commodities, Gold and Listed Private Equity.

Looking at selected ETF proxies for each of these asset classes, the correlations for these Liquid Alternative Assets, relative to Global Equity are summarised below.
Fig.1. Liquid Alternative Assets: Correlation Matrix

Incorporating these exposures within a multi-asset strategy provides can provide diversification benefits, both from an asset-based perspective and a risk-based perspective.
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Looking at 5 year annualised performance, only Gold has outperformed Global Equities. Listed Private Equity has been comparable.  Meanwhile Infrastructure has outperformed property, whilst Commodities have been lack-lustre.

Fig.2. Liquid Alternative Assets Returns vs Global Equities

Looking at performance YTD, gold has returned +31.06% in GBP terms, outperforming Global Equities by 32.54ppt.  Infrastructure has also slightly outperformed equities owing to its inflation protective qualities.
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Fig.3. YTD performance of Liquid Alternative Assets (GBP terms)

Source: Elston research, Bloomberg data

Liquid Alternatives: Strategies
We define Liquid Alternative Strategy ETFs as tradable ETFs that provide alternative asset allocation strategies.  By providing differentiated risk-return characteristics, these ETFs should provide diversification and/or reflect a particular directional bias.
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Fig.4. Examples of European-listed Liquid Alternative Strategies

Each of these strategies provide a low degree of correlation with Global Equities and therefore have diversification benefits.
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Fig.5. Liquid Alternative Strategies: Correlation Matrix

In 2020, the Market Neutral strategy has proven most defensive.
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Fig.6. Liquid Alternative Strategies: YTD performance

Source: Bloomberg data, GBP terms, as at July 2020
Conclusion
ETFs offer a timely, convenient, transparent, liquid and low-cost way of allocating or deallocating to a particular exposure.

Blending Liquid Alternative ETFs – both at an asset class level and a strategy level - provides managers with a broader toolkit with which to construct portfolios.

• Options overlays can be used to create an alternative payoff profile
• Covered call and written put strategies are typically defensive for sideways markets/downside protection
• The ETF format enables access, economies of scale, transparency and timeliness

 
Why use options overlays?
Managers of larger investment portfolios sometimes use options overlays to create an alternative payoff profile relative to a straightforward “long-only” equity holding of a share or index.  This is done to reflect a particular investment view.
Examples of options overlay strategies include Covered Calls and Put Writes.  These strategies to protect investments when markets move sideways and there is higher potential for downside risk.  This typically comes at the expense of explicit costs and foregone returns.
What is a covered call strategy?
A Covered Call strategy combines a holding in equities with sales of call options (an option to buy an equity at a given price within a specific time) on those equities.  In other words, it can be seen as sacrificing unknown future gains on equities in exchange for a known income today.  These aim is 1) to generate returns through income from those sales and 2) reduce downside risk.
What is a written put strategy?
A Put Write strategy combines a cash exposure with sales of put options (an option to sell an equity at a given price within a specific time) on those equities, with the aim of generating an income from option sales whilst providing a cushion during market downturns.
What’s new?
UBS has launched a range of four ETFs that offer a choice of two underlying exposures (S&P 500 or Euro Stoxx 50) combined with these two types of options overlay strategies to give investors access to these defensive strategies that perform better in sideways or downward markets.  The ETFs available are:
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Fig.1. UBS UCITS ETFs incorporating options strategies

Source: Elston Research, Bloomberg data
What does this launch mean for investors?
The launch of these ETFs gives investors of any size the opportunity to access these options overlay strategies within a fund exposure, rather than outwith a fund exposure, meaning that they benefit from:

1. access to the strategy in a way where there are economies of scale (rather than on a bespoke portfolio basis);
2. consistency and transparency of and index-based approach providing a standardised format for all investors within the fund;
3. timeliness to allocate or deallocate to that strategy quickly and conveniently.

Are covered call strategies new within a fund structure?
Not really.  Covered call strategies are used to enhance the income of traditional OEICs in the “Enhanced Income” sector.  Funds such as the Schroder Income Maximiser and Fidelity Enhanced Income use a covered call strategy within the fund to generate additional income at the expense for capital growth, as did Enhanced Income ETFs from BMO.  But this is typically done for yield enhancement rather than as a pure defensive strategy.  These UBS ETFs are not yield focus but are using that additional income to provide some cushioning.
Why the ETF format?
The advantage of the ETF format means that investors have the ability to allocate or deallocate to that strategy quickly and conveniently.  As we saw in March, in period of heightened daily volatility, the 4-5 day dealing cycles (8-10 days for an unfunded switch) of traditional OEICs create significant and unintended market timing risk.  The ETF format offers a more timely way of adding or removing a particular exposure.
Who might use these?
Discretionary managers and financial advisers using platforms that can access ETFs may find these strategies a useful addition to the toolkit as a Liquid Alternative strategy.
Are these Liquid Alternative ETPs?
Yes, we would classify them as such.  But we differentiate between Liquid Alternative Asset Classes and Liquid Alternative Strategies.  We would classify these ETFs as Liquid Alternative Strategies, alongside Managed Futures ETFs and Equity Market Neutral ETFs.
What are the drawbacks?
From a UK perspective, whilst the S&P500 product will be a useful proxy for overall market risk, it’s disappointing that there is these overlay strategies are not available for the UK’s FTSE 100 index as that would be of more appeal for UK investors, advisers and managers.
Furthermore, financial advisers using traditional fund-based platforms will not be able to access these type of options overlay strategies, limiting potential usage.
Performance Track record
Whilst the ETFs are new, the underlying indices has been created with data back to July 2012.
In the 8 years to end July 2020 in USD terms, the US Equity Defensive Covered Call Index returned +11.09%, compared to +13.71% for the S&P 500.  The foregone returns being part of the cost of downside protection.  By contrast, the maximum monthly drawdown (in March 2020) for the Covered Call index was -10.74%, compared to -12.51% for the S&P500, a -14% reduction in drawdown.
Over the same time frame, the US Equity Defensive Put Write Index returned +3.81% compared to +2.88% for US Treasuries.  By contrast, the maximum monthly drawdown (in March 2020) for the Put Write index was -8.14%.
Fig.2. Performance vs selected comparators

Source: Bloomberg data, 31st July 2012 to 31st July 2020, USD terms
In the 1 year to July 2020, the annualised daily volatility of the Covered Call Index was 29.75% compared to 34.10% for the S&P500 (a 12.8% reduction)
In more normal markets – in the 3 years to December 2019, the volatility of the Covered Call Index was 12.27% compared to 12.89% (a 4.8% reduction)

Conclusion
On our analysis, the Put Write index should work well in providing consistent returns in sideways markets in excess of cash/government bonds, but is not immune from severe market shocks.
The Covered Call Index provides a defensive bias whilst maintaining the potential for returns from the underlying exposure.
At a TER of 0.26%-0.29% the strategies are reasonably priced relative to either creating a bespoke options strategy or compared to the OCF of traditional OEICs with embedded options overlays.  Nonetheless, a FTSE 100 exposure would be additionally welcome.

NOTICES
Commercial Interest: Elston Consulting Limited creates research portfolios and administers indices that may or may not be referenced in this article.  If referenced, this is clearly designated as such and is to raise awareness and provide purely factual information as regards these portfolios and/or indices.
Image Credit: Shutterstock