The Next Investing Frontier: Liquid Alternative ETFs
The following content is sponsored by IndexIQ.
The Next Investing Frontier: Liquid Alternative ETFs
Think back to your desires five years ago. As you’ve changed and the world around you has shifted, chances are your desires have also evolved. Similar progressions can be seen in the investing realm.
As investors have become more sophisticated, they have sought securities that provide:
- Enhanced transparency
- Lower fees
- Increased liquidity
This changing behavior paved the way for emerging investment opportunities, including liquid alternative ETFs. In today’s infographic from IndexIQ, we explain what liquid alternative ETFs are, explore their benefits, and discuss how to use them in a portfolio.
What Are Liquid Alternative ETFs?
In order to define liquid alternative ETFs, it’s easier to break the term into two parts: liquid alternatives and ETFs.
Liquid alternatives are baskets of securities with exposure to alternative strategies. They can be accessed through ETFs, mutual funds, or closed-end funds with daily liquidity. Alternative investments are any asset that is not a stock or bond, such as commodities, real estate, or private equity.
ETFs are baskets of securities that trade on an exchange. They can contain various asset classes including stocks, bonds, commodities, or a mixture.
The benefits of ETFs have been combined with the benefits of liquid alternatives to form a relatively new investment opportunity: liquid alternative ETFs.
Liquid alternative ETFs are the subset of liquid alternatives that trade on an exchange. However, they are not widely used yet. In a recent survey, only 8% of institutional investors currently use them, or have used them in the past. Why aren’t more investors adding them to their portfolios?
Misconceptions about Liquidity
Simply put, there’s limited usage because investors lack understanding of the asset class. In fact, institutional investors view “liquidity during market stress” as the #1 disadvantage of liquid alternative ETFs.
In reality, liquid alternative ETFs are sufficiently liquid in most market conditions. ETFs benefit from two layers of liquidity: the liquidity of the ETF itself, and the liquidity of the underlying securities, known as implied liquidity.
Implied liquidity is accessed through market makers, typically large banks, that facilitate investor fund flows. If there is:
- Excess demand: Market makers buy the underlying securities, and sell ETF units.
- Excess supply: Market makers buy ETF units, and sell the underlying securities.
When investors sell ETF units for extended periods of time, market makers have many options at their disposal:
- Sell the individual underlying securities, adjusting their pricing to ensure profitability
- Hold ETF units and their underlying securities until the selling pressure dies down
- Hedge their risk by purchasing derivative instruments or ETFs from other market segments
This range of options ensures liquid alternative ETFs remain liquid, even in volatile markets.
Liquid alternative ETFs offer several key benefits for investors looking to branch out from their traditional portfolios.
The average expense ratio for all 55 U.S. alternative ETFs is just 1.04%. In comparison, hedge funds charge an average management fee of 1.3%—plus a 20-30% performance fee.
In contrast to some alternative investments, liquid alternative ETFs provide a high degree of transparency in terms of investment strategy, holdings, reporting, and fees.
Liquid alternative ETFs have exhibited low correlations with traditional asset classes. Historically, this has provided increased diversification and mitigated risk.
In addition to their many benefits, liquid alternative ETFs are quite versatile in their applications.
Liquid Alternative ETFs in Practice
Institutional investors use this asset class in three main ways.
- Core Component: Investors use liquid alternative ETFs strategically as a long-term, diversifying portfolio component.
- Transition Management: While cash and money market funds are the most common transition vehicles, alternative ETFs provide efficient market exposure at a reasonable cost.
- Fund-of-funds replacement: Many institutional investors use fund-of-funds in their alternative portfolios, but this strategy brings additional fees, a lack of transparency, and potential overdiversification. Liquid alternative ETFs are a compelling replacement.
Whether an investor has short-term or long-term needs, liquid alternative ETFs are a useful tool.
Poised for Growth
With numerous benefits and applications, liquid alternative ETFs are gaining traction. In fact, the market is expected to grow nearly 2.5x by the end of 2020, from $47 billion to $114 billion.
As more institutional investors gain an understanding of this versatile asset class, they will be poised to implement a powerful tool that helps them achieve their clients’ goals.
Visual Guide: The Three Types of Economic Indicators
From GDP to interest rates, this infographic shows key economic indicators for navigating the massive U.S. economy.
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A Visual Guide to Economic Indicators
Economic indicators provide insight on the state of financial markets.
Each type of indicator offers data and economic measurements, helping us better understand their relationship to the business cycle. As investors navigate the market environment, it’s important to differentiate between the three main types of indicators:
The above infographic from New York Life Investments shows a road map of indicators and what they can tell us about the economy.
What’s Ahead: Leading Indicators
Leading indicators present economic data that point to the future direction of the economy like a sign up ahead. Here are three examples.
1. Consumer Confidence Index
This key measure indicates consumer spending and saving plans. When the index is above 100, consumers may spend more over the next year. In December, the index jumped to 108 up from 101 in November. This was in part due to lower inflation expectations and improving job prospects.
In the December survey, 48% indicated that the job market remained strong, highlighting the strength of employment opportunities and likely influencing sentiment towards spending in the future.
2. ISM Purchasing Managers Index
The ISM Purchasing Managers Index indicates expectations of new orders, costs, employment, and U.S. economic activity in the manufacturing sector. The following table shows how the index is broken down based on select measures:
|Index||Nov 2022||Oct 2022||Percentage|
For instance, in November the index fell into its first month of contraction since May 2020. Falling new orders signal that demand has weakened while contracting employment figures indicate lower output across the sector.
3. S&P 500 Index
The S&P 500 Index indicates the economy’s direction since forward-looking performance is factored into prices. In this way, the S&P 500 Index can represent investor confidence as the index often serves as a proxy for U.S. equity markets. In 2022, returns for the index are roughly -20% year-to-date.
Current Conditions: Coincident Indicators
Coincident indicators reflect the current state of the economy, showing whether it is in a state of growth or contraction.
GDP indicates overall economic performance. Typically it serves as the most comprehensive gauge of the economy since it tracks output across all sectors. In the third quarter of 2022, real U.S. GDP increased 2.9% on an annual basis. That compares to 2.7% for the same period in 2021.
2. Personal Income
Rising incomes indicate a healthier economy and falling incomes signal slower growth. Personal income grew at record levels in 2021 to 7.4% annually amid a rapid economic expansion.
This year, U.S. personal income has grown at a slower pace, at 2.7% on an annual basis as of the third quarter.
3. Industrial Production Index
Strongly correlated to GDP, the industrial production index indicates manufacturing, utilities, and mining output. Below, we show trends in industrial production and how they correspond with GDP and personal income indicators.
*As of Q3 2022.
As the above table shows, factory production collapsed following the 2008 financial crisis, a key indicator for the depth of an economic downturn. Meanwhile, personal income sank over -3% while GDP fell -2%.
Despite economic uncertainty in 2022, industrial production remains positive, at a 4.7% growth rate, albeit somewhat slower than 2021 levels.
Rearview Mirror: Lagging Indicators
Like checking your back mirror, lagging indicators take place after a key economic event, often confirming what has taken place in the economy. Here are three key examples.
1. Interest Rates
Often, interest rates respond to changes in inflation. When rates rise it can slow economic growth and discourage borrowing. Rising interest rates typically signal a strong economy and are used to tame inflation. On the other hand, low interest rates promote economic growth.
Following years of record-low interest rates, the Federal Funds rate increased at the fastest rate in decades over 2022, jumping from 0.25% in March to 4.25% in December as inflation accelerated.
2. Consumer Price Index
This inflation measure can indicate cash flow for households. Inflation is often the result of rising input costs and increasing money supply across the economy.
Sometimes, inflation can reach a peak after an expansion has ended as rising demand in an economy has pushed up prices. In November, U.S. inflation reached 7.1% annually amid supply chain disruptions and price pressures across food prices, medical prices, and housing costs.
|Year||Inflation Rate||Annual Change|
*As of November 2022.
3. Unemployment Rate
The unemployment rate has many spillover effects, impacting consumer spending and in turn retail sales and GDP. Historically, unemployment falls slowly after an economic recovery which is why it’s considered a lagging indicator. When the unemployment rate rises it confirms lagging economic performance.
Overall, 2022 has been characterized by a strong job market, with unemployment levels below historical averages, at 3.7% as of October.
On the Road
To get a more comprehensive picture of the economy, combining a number of indicators is more effective than isolating a few variables. With these tools, investors can gain more perspective on the cyclical nature of the business cycle while keeping a long-term perspective in mind on the road ahead.
Europe’s Energy Crisis and the Global Economy
Europe’s energy crisis could last well into 2023. Here’s how the energy shock is causing ripple effects across the broader economy.
This infographic is available as a poster.
Europe’s Energy Crisis and the Global Economy
Volatile energy prices are squeezing household costs and business productivity in Europe.
While energy prices have fallen in recent months, several factors could influence price volatility looking ahead:
- Russia slashing energy supplies
- Rising winter heating demand
- Shrinking European storage facilities
In the above infographic from New York Life Investments, we show the potential impacts of Europe’s energy crisis on consumers, businesses, and the wider global economy.
1. Impact on Consumers
Energy plays a central role in overall inflation. Here’s how it factors into the consumption baskets of various countries:
|Total Inflation Rate|
|Energy||Food||All Items Less Food
Source: OECD (Oct 2022). Annual inflation is measured by the Consumer Price Index.
As the above table shows, energy makes up nearly half of consumer price inflation in Germany. In the U.S., it contributes to about one-fifth of overall inflation.
Amid energy supply disruptions, U.S. winter heating costs are projected to rise to the highest level in a decade. As heating costs rise, it could impact consumer spending on discretionary items across the economy, along with other essential household bills.
2. Impact on Business
Natural gas and petroleum are key components in many industries’ energy consumption. As a result, the recent rise in energy prices is adding significant cost pressures to operations.
Below, we show how four primary sectors use energy, by source:
|U.S. Sector||Petroleum||Natural Gas||Renewables||Coal||Electricity|
Source: EIA (Apr 2022). Figures represent end-use sector energy consumption in 2021.
In Europe, soaring energy prices have led to production declines in energy-sensitive industries over recent months. As a ripple effect, European fertilizer production capacity has decreased as much as 70%, crude steel capacity has fallen 10%, and aluminum and zinc production capacity has sunk 50%.
In response, some companies may move production out of Europe to regions with lower energy prices. This occurred in 2010-2014 amid high European energy prices, where companies relocated to the U.S., the Middle East, and North Africa.
3. Impact on the Economy
While the energy crisis is having devastating effects on many countries, some markets like the U.S. are more sheltered from the impact. As seen in the table below, the U.S. produces virtually all of its natural gas. Figures are shown in trillion cubic feet.
|Year||U.S. Natural Gas|
|U.S. Natural Gas|
Source: EIA (Sep 2022).
By contrast, Europe imports 80% of its natural gas, primarily from Russia, North Africa, and Norway. Not only that, natural gas imports have increased over the last decade, up from 65% of total supplies in 2010.
Meanwhile, the energy sector is seeing strong returns supported by higher oil and natural gas prices, along with key fuel shortages as Russia constricts supplies to Europe. In November the S&P 500 Energy Index was up 65% year-to-date compared to the broader index, with -17% returns.
Europe’s Energy Crisis: Looking Ahead
Given the complex geopolitical environment, Europe’s energy crisis could last well into 2023, driven by many factors:
- Rising demand from China post-COVID-19 lockdowns
- Lower European fuel reserves
- Inadequate energy infrastructure in the medium-term
The good news is that European government relief has reached €674 billion ($690 billion) to cushion the effect on households and businesses.
However, this has additional challenges as increasing money supply may be an inflationary force.
Amid market volatility, investors can avoid getting caught up in short-term market movements and stay focused on their long-term strategic allocation.
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