Asset managers and fund/ETF promoter are always on the hunt for the next “big thing” that can be sold to investors at an attractive margin. While we have seen a lot of innovations in the European ETF industry which helped investors implement their views on specific market segments into the asset allocation of their portfolios, the idea of investing in private markets needs, at least, to be seen as concerning when it comes to ETFs. This is because it has proven in the past that a mismatch of liquidity and/or maturities can be fatal for investors. Therefore, wrapping assets with a (very) limited liquidity and a low pricing frequency into a product which is expected to offer (more or less) permanent liquidity based on an ongoing pricing during each trading day might be a bad idea.
After the European ETF industry has made literally all liquid asset classes investable by launching ETFs with respective underlying assets, promoters are looking for opportunities in private markets. As the assets on these markets do not offer daily liquidity, promoters have to find a way to use these assets in ETFs. One way to reach this is to blend illiquid assets with liquid assets with a similar return profile. As a result, an ETF can offer the liquidity needed and expected by investors while still maintaining the risk/return-profile of a targeted private market—this may be in a bond segment such as collateralized loan obligations (CLOs) or in an equity segment such as private equity. That said, the exposure to liquid assets will water down the exposure to the respective private market assets and, therefore, have an impact on the return expectations of the respective ETF.
But what happens in times of market turmoil? While anything may work as expected on a small scale, the trouble may start when investors want to sell the respective asset class on a broad scale. In this case the possible lack of buyers may lead to limited liquidity, especially for the private assets. Within such a scenario the ETF may sell the liquid assets first to fulfill the redemptions of the investors. Once the liquid assets are sold, the remaining investors are stocked in an illiquid investment product and can’t sell it on demand. Even if the respective ETF might have a possible “in-kind delivery mechanism” in its prospectus for such market environments, I am pretty sure that investors don’t want to receive assets (which they have to sell by themselves) instead of cash when they sell an ETF.
Such a situation would not only harm the respective ETF and its promoter. Such a situation would harm the overall ETF industry. With regard to this, I don’t think that private markets are an appropriate underlying asset for ETFs because single products risk damaging the reputation and integrity of the whole ETF industry.
This article is for information purposes only and does not constitute any investment advice.
The views expressed are the views of the author, not necessarily those of Lipper or LSEG.
