One area of individual exchange-traded funds that is growing the fastest is alternative investments. Individual owners will probably feel bad about this.
There was a report in the Wall Street Journal that the biggest discount broker in the U.S., Charles Schwab, said it would launch “an alternative investments platform for individual investors” later this year. Investors could use the tool to get into “private equity, venture capital, private credit, and hedge funds,” among other alternative investments.
There’s no denying the appeal of these kinds of different investments, especially now that the U.S. stock market looks overvalued and the bond market is having a tough time. Rich people could only make these kinds of investments for a long time, and for a while they were very successful. One example is Yale University’s fund, which was run by the late David Swenson.
But the alternatives group has been struggling for at least ten years, and it’s funny that managers of alternative assets have decided to let individual investors in when they used to not let them in. There’s no doubt that they’re not doing this out of a desire to share the income.
The poor success of pension funds and college/university endowments that put a lot of their money into alternative investments makes me more skeptical. Institutional Investor quoted Richard Ennis last year as saying that “alpha appears to respond to the presence of alts [alternative investments] as if the latter were kryptonite—the greater the exposure, the harsher the effect on alpha.” Ennis co-founded one of the first investment consulting firms on Wall Street and was the editor of the Financial Analysts Journal.
It’s not a big surprise, then, that individual buyers have also had a hard time with alternative investments. Look at how the 50 ETFs in VettaFI’s “Alternatives” group have done. The chart below shows that these funds have generally done worse than the S&P 500 SPX over the last one, five, and ten years. Also, they have always been behind the standard 60/40 stock-bond portfolio.
Lots of fees cut into returns
There is also good reason to be skeptical because there are a lot of new alternative ETFs with high cost ratios. Researchers have found that these kinds of funds usually fall behind the market for up to five years after they are first put in place.
There are two connected reasons for this. The first is that ETF providers are releasing new products that focus on the most popular investment ideas. They can charge bigger expense ratios because of this. Higher costs, on the other hand, make it harder for a fund to do well. The core portfolios of these ETFs are also likely to be overvalued because they hold the most popular investments.
VettaFI has 50 ETFs that are called “alternatives.” Eleven of them are less than one year old, and 26 are less than three years old. ETF.com says that the average cost ratio for these 50 funds is 1.05% of assets, which is a lot more than the average for equity ETFs, which is 0.16%. The average cost of these ETFs is even higher than the others, at 1.21% for those that are less than a year old.
A new study in the Review of Financial Studies says that paying above-average managing fees for investments that are worth more than they are worth is a bad combination. The study was done by Itzhak Ben-David and Byungwook Kim of The Ohio State University, Francesco Franzoni of the University of Lugano in Switzerland, and Rabih Moussawi of Villanova. It was called “Competition for Attention in the ETF Space.”
Ben-David wrote in an email, “Given that so many new alternatives-focused ETFs with high fees have come out recently, it’s a good bet that they will underperform for at least the next couple of years.” Our research shows that shorting industry and theme-based ETFs is the best way to invest in them.
