Asset managers want liquid ETFs for illiquid private equity

Invesco and BlackRock are asset managers, which means that they are in the business of providing investors with vehicles to invest in their choice of assets. One vehicle that these companies use to meet this need is exchange traded funds, or ETFs.

ETFs have exploded in popularity over the last decade, growing from a $1.3 trillion asset class in 2010 to 10 trillion in 2021, and investors prefer them over other vehicles, such as mutual funds, for a few reasons:

• ETFs trade like stocks, and they can be bought and sold throughout the day.

• Many ETFs are passively managed, leading to lower fees.

• ETFs don’t require minimum initial investments.

• ETFs often have lower capital gains costs than other fund structures.

One asset class that has been largely closed off to retail investors has been private equity. A 2022 report from Cambridge Associates shows that US private equity has outperformed public equities over the last 25 years, returning 13.33% annually, vs. a ~9% CAGR from the S&P 500 (including dividends) over that period.

So, naturally, retail investors want access to private equity, and, according to Bloomberg, BlackRock and Invesco are reportedly looking to offer private market ETFs to meet this need. The issue, as you could guess, is that a liquid ETF, which trades throughout market hours, holding illiquid assets, which are rarely traded, just doesn’t make sense.

To illustrate the issue, here’s a brief primer on how ETFs work:

Each day, ETF providers publish lists of assets that will go in the ETFs portfolio, and ETF shares are created when institutional investors called “authorized participants,” or “APs,” submit orders for creation units, which consist of ~25,000 to 250,000 ETF shares. The APs buy the assets on an ETF provider’s list and exchange the underlying assets for shares of the ETF. Then, the AP is free to hold the ETF shares or sell them on the open market. APs can also redeem ETF shares for underlying assets by doing this process in reverse.

Making an ETF that mirrors the S&P 500 is easy, because its components are publicly traded and authorized participants have no issue buying shares. Making an ETF that mirrors private assets, however, is a different beast, because you can’t just go buy shares of illiquid companies each day to meet investor demands. Additionally, the valuations of publicly traded stocks and bonds are marked to market, meaning that the ETF should more or less trade in-line with the real-time value of its underlying components. Private asset valuations are largely static, excluding fundraises or instances when investors publicly update their internal valuation models (a practice not unfairly dubbed as “mark to make believe”). 

Bloomberg noted a few options that ETF providers were considering to navigate the logistical issues of applying an ETF wrapper to private assets:

One potential solution to the mismatch is via so-called synthetic exposure, whereby a fund wouldn’t actually hold private assets but would contain swaps written against a private equity portfolio…

Another option would be to attempt to mimic the performance of private-asset investments in a so-called liquid alternative ETF. These funds, known as liquid alts, use tactics like leverage, short selling and derivatives to replicate strategies, often trying to ape popular hedge fund styles.

I personally think that, instead of asset managers trying to sell private market ETFs that use complex “synthetic exposure” or leverage-heavy “liquid alts” to retail investors, more highly-valued private companies should just go public, opening the door for all investors to invest.