By Aaron Filbeck, CAIA, CFA, CFP®, CIPM, FDP
Managing Director, Head of UniFi by CAIA™ at CAIA Association
In case you missed it, a flurry of ETF proposals have attempted to integrate private credit into their offerings, effectively providing private credit to the masses. It’s still early days, but these proposals are likely not over. As I continue to learn more about the different offerings, my inner monologue channels the great Benoit Blanc from Knives Out (2016):
“It makes no damn sense…! Compels me though…”
Innovation is awesome and should be encouraged in this industry. In wealth management, we’ve gone from a stockbroker’s world, the (usually uninformed) gatekeeper to the capital markets, to the holistic financial advisor. Mutual funds democratized diversification, ETFs democratized broad market exposure, and technology has reduced fees and frictions. All very good stuff.
So far, the proliferation of private market products has focused on finding ways to open access for high-net-worth individuals in a way that presents a win-win for the GP and investor.
For the investor, these products provide:
Operational ease (relative to drawdown funds)
More immediate capital deployment vs. capital calls/commitments
Scale across their practice and many households
Tax-friendly reporting
Availability and access for lower minimums
For the GP, these products provide:
Access to a new investor base
Scalable (perpetual) fundraising
Recurring fee revenue
The rise of semi-liquid/evergreen/registered products has been swift but still pales in comparison to the incumbent drawdown fund complex. According to Preqin, evergreen funds are somewhere shy of $400 billion (see Figure 1), whereas drawdown funds are nearly 40x that figure in AUM).
Figure 1: Evergreen Fund AUM
Source: Pitchbook
I would argue that this evolution is a net positive so far – the structure itself is imperfect, but it provides a way for high-net-worth investors to access private capital. Thus far, most of the asset classes being put in these vehicles are the relatively stable, income-generating, types – such as credit and real estate, as shown in Figure 2. (Note: I realize these assets are not necessarily fundamentally stable at all times but are relative to more aggressive assets like private equity, digital assets, or long-biased hedge funds.)
Figure 2: Non-Listed CEFs by Asset Class
Source: XA Investments
So What’s the Problem?
“I spoke in the car about the hole at the center of this doughnut. And yes, what you and Harlan did that fateful night seems at first glance to fill that hole perfectly. A doughnut hole in the doughnut's hole. But we must look a little closer. And when we do, we see that the doughnut hole has a hole in its center - it is not a doughnut hole at all but a smaller doughnut with its own hole, and our doughnut is not whole at all!”
Like Mr. Blanc’s doughnut, what seems so simple at face value becomes increasingly complicated when implementing these products. Every alts + wealth conference features a discussion of these semi-liquid wrappers and how to better understand them. Without mentioning organizations, we’ve also seen headline-worthy case studies where investors still use these funds as trading vehicles rather than long-term investments with a liquidity option, should they need it. The wrapper may matter, but so does the investor. The benefit of these vehicles, though, is that protection levers can be pulled to protect capital, known as gates. It may not make you happy, but it’s there for a reason – to protect the investors who knew what they signed up for.
Private Credit ETFs: Knives Out?
“I suspect foul play, and I have eliminated no suspects.”
Many of the mechanisms incorporated into semi-liquid funds are not in place for ETFs – no gates, no soft or hard closes, no restrictions on the investors. Therefore, we need to take a step back and really think about the implications of offering private credit in an ETF wrapper. Yes, the ETF is a fantastic invention and provides many benefits over mutual funds in terms of fees, tax efficiency, and transparency. And yes, more investors are familiar with ETFs than they are semi-liquid vehicles. However, while there may be an occasionally uncomfortable misalignment in liquidity between the asset and the semi-liquid wrapper, ETFs present little-to-no alignment at all.
As John Maynard Keynes once said, “the market can remain irrational longer than you can remain solvent.” Even if your strategy is sound, the wrapper can be damaging when all is laid bare. Importantly, your underlying investors matter. Over the past decade, there are plenty of examples where these factors were at odds and, unsurprisingly, resulted in bad outcomes – typically a strategy being wound down – and these weren’t even traditionally illiquid assets!
Examples in recent history include (but are not limited to) Third Avenue (junk bonds) and Whitebox (market neutral) in 2015, VelocityShare (short volatility) in 2018, and Infinity Q (absolute return) in the early 2020s.
Long-Term Investments vs. Long-Term Investors
These examples merely illustrate that when there is a trifecta mismatch in 1) the asset liquidity, 2) the wrapper liquidity, and 3) the investor time horizon – things end badly.
As discussed in a recent Capital Decanted episode, everyone is a long-term investor until they’re not, and there’s a difference between long-term investments and long-term investors. You can be a long-term investor and hold public market vehicles, and you can be a short-term investor and hold private market vehicles – it just won’t work in your favor if it’s the latter.
The average holding period for a stock has declined from seven years in the 1950s to less than one year today, as shown in Figure ___. Similarly, a paper back in 2013 found that the average holding period of an ETF was 121 days. Are we in a scenario where we’re now introducing products that violate that trifecta?
Figure 3: Average Holding Period for a Stock on the NYSE (Years)
Source: Dresdner Kleinword Macro Research
So, if investors still haven’t wrapped their heads around interval funds, tender offer funds, non-traded REITs and BDCs that all offer periodic liquidity, are we moving too fast? Who is this for?
Private Credit ETFs: Questions to Ask
I’m going to assume the train has left the station on this issue and therefore want to offer a few important considerations you should make before investing:
What am I trying to accomplish? If you aim to gain pure private credit exposure, investing in an ETF will not be for you. These vehicles have limits on illiquidity (15%); therefore, you’re more likely to own an investment-grade corporate bond ETF with some octane. Is that worth it?
How will this obvious liquidity mismatch be handled? While there is still a mismatch, you can argue that private credit in a semi-liquid vehicle is at least possible – these loans (when performing) kick off regular cash flow, and redemptions are limited.
What “private credit” are we talking about? Not all “private credit” ETF launches have been the same – some want to invest in private loans directly, others want to own listed BDCs or CLOs, and everything in between. You should understand what you’re actually owning and the implications for your portfolio.
How is value determined for illiquid assets in an ETF? We didn’t even discuss valuations in this post, but it’s an important consideration. We’ve compressed the valuation cycle of private assets from quarterly to daily in an ETF wrapper. Bond math is easier than most, but it’s important to know how the underlying loans will be valued, when they’ll be valued, and how any trades that hit the underlying basket vs. the secondary market exchange of shares are realized vs. their intra-period valuation. Also, who is valuing and transacting them?
Who is investing alongside me? You don’t want to be caught holding the bag. In illiquid or even semi-liquid vehicles, you’re either structurally forced to be a long-term investor, or the restrictions weed out typically more skittish investors.
Private markets are more complex than public markets, and their vehicles require more work to understand. But the work is important and worth it if you ultimately want to do this. We want to make access easier, but not by circumventing the important pillars of due diligence, transparency, and long-termism.
About the Contributor
Aaron Filbeck, CAIA, CFA, CFP®, CIPM, FDP, is Managing Director and Head of UniFi by CAIA™ at CAIA Association. His industry experience lies in private wealth management, where he was responsible for asset allocation, portfolio construction, and manager research efforts for high-net-worth individuals. He earned a BS with distinction in finance and a master of finance from Pennsylvania State University.
Learn more about the CAIA Association and how to become part of a professional network that is shaping the future of investing, by visiting https://caia.org/.