Winter 2022

Revisiting Alternatives: Using ETFs to Capture Alternative Risk Premia

Interest in Alternative investments has raised considerably in the last few years. In this issue of THE VAULT, Mark Webster, Director, Institutional & Advisory, discusses how paltry yield from traditional safe haven bonds, and the spectre that those bonds may decline in price when interest rates rise, has driven investors to examine the diversification and yield benefits in Alternative investments.

Jan. 27, 2022

Canada’s largest pension plans have become global leaders in Alternative investments,1 validating the asset classes and motivating smaller institutional investors to change their investment polices to capture the same risk premia. Though the temptation to emulate may be very strong, there is a fundamental difference between the approach of Canada’s Big 8 pension plans and that of smaller investors. Very large pension plans invest in Alternative asset classes directly or as co-investors with other large Institutions. They can do so because they have sufficient Capital, a long investment horizon and the expertise to execute very thorough due diligence to screen suitable investments. They identify the most attractive opportunities and can fund their investments upon completing their due diligence.

Smaller pension funds, endowments, investment counselling and multi-family offices can adapt their investment portfolios to capture Alternative risk premia, but they must do so through Pools. As a result, they face several obstacles:

  • Due diligence & manager risk: Large, direct investors evaluate the investments directly. Smaller investors who use Pools conduct due diligence on asset managers, a wholly different proposition. By definition, they assume manager risk in addition to any risks posed by the underlying investments;
  • Capacity and scalability constraints and placement delays: Pools take significant time to identify, screen and invest in new Alternative exposures. It can take 12 to 24 months to deploy capital, resulting in significant performance drag; and,
  • Liquidity constraints: Pools may not be able to accommodate periodic rebalancing, which is vital to manage portfolio asset mixes.

Benchmarking performance is one of the most important elements in due diligence; however, Alternative asset classes do not have objective benchmarks to measure and to monitor Alternative Pooled funds. Each fund is highly idiosyncratic, with a unique risk and return profile. Large investors can measure their direct investments as they execute their due diligence and continue to monitor them. Pooled investors, in contrast, do not have the same ability to evaluate the risk and return prospects and, as a result, their risks and returns may be quite different from what was intended.

Several institutional investors have started to evaluate or to implement ETFs, either as holding accounts until capacity is raised or as liquidity tools to facilitate rebalancing. In some instances, an ETF has been used as a proxy to capture Alternative risk premia, overcoming irritating capacity and liquidity constraints. The ETF also provides complete transparency and the validation that comes with an index constructed by a recognized provider, complete with a robust data set to measure risk and return objectively.

Another consideration is the cost of investing in Alternative Pools, an area which has, seemingly, been immune from the fee compression that has been common across traditional asset classes. ETFs provide liquid, transparent, cost effective and scalable exposures to investment counsellors and multi-family offices wishing to enhance their models.

AlternativeETFMandateBenefitYieldBetaCorrelation to Canada Universe BondsCorrelation to S&P 500
Physical InfrastructureZGIGlobal InfrastructureLiquidity & Diversification3.06%1.010.510.42
ZUTCanadian UtilitiesLiquidity & Income3.31%0.960.460.39
ZINCanadian IndustrialsLiquidity & Diversification1.81%0.98-0.030.05
Physical Real EstateZREEqual Weight Canadian REITsLiquidity & Diversification3.87%0.940.490.58
Private DebtZCSShort Canadian Corporate BondsLiquidity / Duration management2.98%n/​a0.820.28
ZCMMid Canadian Corporate BondsLiquidity / Duration management3.30%0.890.28
ZBBBCanadian BBB Corporate BondsLiquidity / Duration management3.24%0.88-0.05
ZSUShort U.S. Corporate BondsLiquidity / Duration management2.94%0.600.40
ZMUMid U.S. Corporate BondsLiquidity / Duration management3.57%0.690.42
ZFHFloating Rate / HY IssuersLiquidity & Diversification4.56%n/​an/​a
ZHPU.S. Preferred Shares (Hedged)Liquidity & Better Credit Quality6.09%0.410.71
ZEFEmerging Market Sovereign BondsLiquidity & Better Credit Quality4.07%0.310.05
Private EquityZSMLU.S. Small Cap EquityLiquidity & Diversification1.03%0.77-0.040.78
ZMIDU.S. Mid Cap EquityLiquidity & Diversification1.03%0.770÷020.85
ZEMEmerging Market EquityLiquidity & Diversification2.23%0.950.280.57
ZINNGlobal InnovationLiquidity & Diversification0.28%0.93-0.060.66
CommoditiesZGDEqual Weight Global Gold ProducersLow / Negative Correlation0.00%0.73-0.010.02

Source: BMO Global Asset Management, as of December 31, 2021. Distribution yield is not an indicator of overall performance yields will change from month to month based on market conditions and is not guaranteed. See appendix for the full disclaimer.

We will hold our first Institutional webinar on this theme on February 16, in association with CIBC Capital Markets. I hope you will join us for a detailed discussion on how these approaches can diversify portfolios. Additional statistical analysis will be provided for your analysis and evaluation.

To learn more, or other ideas to optimize your portfolios, reach out to
your BMO ETF Specialist.

1 AIMA Canada Handbook 2019, A Report on the Canadian Alternative Investment Landscape,” October 152019.


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