Institutional investments in liquid alternative exchange-traded funds (ETFs) will more than double in the next 12 months, according to data from Greenwich Associates.

Liquid alternatives are investment vehicles that deliver exposure to alternative asset classes with daily liquidity. Common vehicles include closed-end funds, mutual funds and ETFs. They began proliferating in institutional portfolios following the global financial crisis, during which many investors with large allocations to alternative asset classes experienced liquidity issues caused in part by relatively long lockup periods.

“For more than 20 years, institutional investors have been adding alternative asset classes to their portfolios. More recently, institutions have been adopting exchange-traded funds (ETFs) as a versatile, jack-of-all-trades portfolio tool,” explained Andrew McCollum, Greenwich Associates managing director and author of 'Liquid Alternative ETFs: The Next Frontier in Institutional Investing'. “The intersection of these trends could ultimately bring about a transformation of alternative investments in institutional portfolios.”

New, novel and growing

Today, liquid alternatives represent about 4% of institutional assets, with average allocations ranging from a high of 6% of total assets among public pension funds to a low of 2% among corporate funds and OCIOs in the US. These allocations represent US$882bn in institutional assets currently invested in liquid alternatives, including US$564bn from public funds.

For most institutional investors, liquid alternative ETFs represent a relatively new and novel vehicle. However, growing numbers of institutions are taking advantage of liquid alternative ETF’s liquidity and relatively low costs in tasks ranging from manager transitions and tactical portfolio adjustments to taking on long-term investment exposures and replacing fund-of-fund investments.

Institutions using liquid alternative ETFs invest an average 3% of total assets to the funds - a significant allocation that brings the current institutional market for liquid alternative ETFs to some US$47bn. However, over the decade that Greenwich Associates has been tracking the use of ETFs in the institutional market, the firm has documented a consistent pattern that has unfolded across institution type, geographic region and asset class: Institutions start with small investments in ETFs, generally for a single, specific tactical task like a manager transition. In short order, they discover that ETFs are not only safe and effective in these tasks, they are also incredibly flexible. Over time, institutions start adopting ETFs into a list of more and increasingly strategic portfolio functions.

Greenwich Associates expects liquid alternative ETFs to follow a similar trajectory. Almost 20% of institutions not currently investing in them say they will consider using liquid alternative ETFs in the year ahead. Meanwhile, roughly one in 10 current investors plan to increase allocations to liquid alternative ETFs in the next year. Greenwich Associates projects that, over the next 12 months, institutional investment in liquid alt ETFs will climb to approximately US$114bn - roughly 2.5 times current allocations.

“Given institutions’ embrace of ETFs in other asset classes and their ample appetite for alternatives, it’s possible - even likely - that large numbers of these investors will experiment with liquid alt ETFs when given an opportunity and that allocations and total investment will rise steadily for the foreseeable future,” said McCollum.