As noted in the introduction to this report, institutional investors generally have significant and increasing exposures to alternatives – notably to hedge funds, private equity, private credit, and private real estate. Such allocations have the potential to diversify and enhance portfolio returns, they are often illiquid (not to mention costly).
Alternatives, as such, present investors with a bit of a conundrum. Investors appreciate the potential return premia of “traditional” alts, but acknowledge they can be significantly illiquid at a time when liquidity needs are pressing down on them. It makes sense, then, that there is growing demand among institutional investors for liquid solutions that are designed to mimic the role of standard alternative allocations in their portfolios. That demand is being met.
Liquid alt proxies
Most institutions regularly conduct reviews of their asset managers, and often as a result decide to reallocate among various alt strategies, resulting in disruption of exposures and benchmarking risks. It is in this scenario that a new use for ETFs has emerged, namely as liquid alternative proxies for short-term exposures to equitize cash during alternative manager transitions. ETFs are being similarly used for longer-term strategies where institutions are looking to reduce cash positions while maintaining liquid exposures.
To create liquid alternative proxies, BlackRock assesses the risk and return profiles of hedge funds, private equity buyout, venture capital, and private real estate, and maps each of these asset classes to the combination of iShares ETFs that efficiently approximates these characteristics. The methodology used adjusts for the effects of private asset class autocorrelation to better estimate risk profiles.
These liquid public proxies can complement the allocations of four private asset classes, allowing institutions to gain flexibility in meeting liquidity needs while helping to mitigate the performance drag that can result from holding excess cash.
To proxy buyout private equity, a three-pronged approach combined academic research, returns-based regressions, and holdings-based analysis of buyout targets. All three approaches identify the value factor as a strong (though not identical) public-market proxy for the private equity return premium. Buyout private equity cannot be fully replicated through public markets, but factor-weighted strategies are attractive alternatives to market cap-weighted strategies.
To proxy venture capital, research has shown the presence of the momentum factor in the regressions. As was the case with the value factor in buyouts, this is a public-market anomaly that can be accessed through an MSCI index in seeking to close the venture capital return premium gap.
