(Bloomberg) -- In the race to open up the multitrillion-dollar private-asset market to retail investors, Apollo Global Management and State Street Global Advisors appear to have jumped ahead of rivals with their breakthrough plan for a new credit ETF.
Now, industry participants are left wondering exactly how the institutional big guns will pull off the feat of marrying famously illiquid holdings with a tradeable investment for the masses.
The two firms filed in early September to launch an actively managed exchange-traded fund that will keep 80% of net assets in investment-grade securities — both publicly traded debt as well as private credit — while allocating as much as 20% toward high-yield bonds.
The fund, called the SPDR SSGA Apollo IG Public & Private Credit ETF, still needs to win US regulatory approval. If successful, though, it would pave the way for unleashing fresh billions into an already booming ETF universe and lead to a raft of copycat products. In their joint statement announcing the plan, State Street executive Anna Paglia described the effort as a way to “democratize access” to a corner of the market that had mainly only been open to big players or high-net-worth investors.
“Whoever can bridge the gap between all that private stuff and the retail investor is probably going to make out big time,” said Bloomberg Intelligence’s Eric Balchunas on Bloomberg’s Trillions podcast.
For that to happen though, the two investment titans will need to prove to regulators that the novel trading strategy behind their plan can function smoothly in practice amid a profusion of market risks, and that it meets Securities and Exchange Commission guidelines.
A chief hurdle lies in reconciling the mismatch in the makeup of the assets and the vehicle. As listed securities, ETFs change hands every second of the day in the cash market, and in extended trading. In contrast, private investments are known for barely changing hands. This raises questions around how the mechanics of the fund would operate — especially in the event of a wave of redemptions amid a major selloff or credit crisis — and how securities that rarely, if ever, trade can be fairly valued.
“Liquidity is a problem, and the ETF structure, by design, is a very liquid structure — the whole point of the ETF,” Cinthia Murphy, investment strategist at data provider VettaFi, said on the ETF Prime podcast of the challenges of getting such funds off the ground. “It’s really difficult to have that creation-redemption mechanism that makes the ETF structure the powerful vehicle it is functioning properly when you’re navigating underlying securities that don’t trade at all.”
Spokespeople at State Street and Apollo said they are unable for regulatory reasons to comment on their pending application. But the firms’ filing describes the general framework for overcoming current regulatory strictures around putting illiquid assets in an ETF structure.
Under their plan, the fund would invest in private credit via debt sourced by Apollo as well as other instruments. Apollo would serve as a liquidity provider for the debt it sources, contractually agreeing to “provide intraday, executable firm bids” on the investments. And it would offer to buy them back from the fund at State Street’s discretion, subject to an as-yet unspecified daily limit.
In principle, Apollo’s agreement to provide bids for the private debt it sources would allow that portion to be deemed liquid. And the firm is separately involved in efforts to build out a trading desk for private-credit loans, part of moves by some big players to make markets in the debt so it is easier to value, buy and sell.
But industry experts still see potential issues with this type of structure, including Apollo’s role and how valuations on some of the private debt will be set.
“The caveat is we don’t build these products for the average day, we build these products for the bad days,” said Dave Nadig, an ETF industry veteran.
The fund’s prospectus cites the risk that Apollo isn’t able to meet its obligation to provide bids for investments it sourced, in which case they may be deemed illiquid. This is significant because US regulations only allow open-ended funds to hold 15% of their holdings in such assets.
There are also potential challenges around Apollo’s buyback limit, a topic that was raised in a recent report by Morningstar Inc. analysts Brian Moriarty and Ryan Jackson. Namely, they raise questions about how the fund would perform during times of market stress. Morningstar envisions a scenario whereby the ETF sees outflows but Apollo’s daily limit — the buyback cap — isn’t big enough to keep up with redemptions.
“That could force State Street to sell more-liquid public securities first, in turn potentially leaving the ETF with more in illiquid private credit instruments as a percentage of assets and increasing the risks for further liquidity crunches,” the Morningstar analysts wrote. “A lot depends on Apollo’s daily liquidity limit and its ability to satisfy it as the ETF grows.”
Of course, the ETF industry has had success in finding ways to package hard-to-trade assets — like fixed income, gold or Bitcoin — into an ETF wrapper, all without major issues, said Bloomberg Intelligence’s Balchunas. In addition, State Street has a solid track record within the space, and it’s possible more information is still to come out on how the fund would operate.
“There haven’t been many situations where ETFs have not served their investors well,” he said. “The trust and goodwill from the industry over the years, as well as this intelligence and adaptability of the users — I think they’re ready for this and I think they’ll roll with it.”
But Nadig foresees a long road before any potential launch.
“They put this filing in and now the staff is reviewing it inside the SEC, and then the staff will send them back 400 questions,” he said.
--With assistance from Sam Potter and Isabelle Lee.
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