Why Hedge Fund ETFs Make Sense

A new breed of passively managed hedge funds would give investors a benchmark to judge the returns of traditional active hedge funds

Alastair Kellett 24 September, 2012 | 5:00AM

Over the last two decades, the mainstream emergence of passive strategies for running stock and bond portfolios has shaken up the fund universe, affecting investor behaviour and the way traditional fund managers are perceived, evaluated, and compensated.

In the same way, there is still much more room for passive management to have an impact on hedge funds.

Hedge funds have always done their own thing, cosseted from the broader world of wealth management by rules around who can and can’t invest in them, and chasing profits in ways and places that traditional investment vehicles are unwilling or unable to pursue. Being un-benchmarked and uncorrelated has historically let them charge a premium for their work: the typical hedge fund comes with a 2% annual management fee, and an incentive fee of 20% of the fund’s profits.

Being un-benchmarked and uncorrelated has historically let [hedge fund managers] charge a premium for their work

But not every hedge fund manager can be the best at what he or she does. There are many more funds than there were a decade ago, so on average the managers likely aren’t as good. They are managing much more money, which means they have to allocate it beyond their top ideas. And in many cases they are working from very similar playbooks and crowding into the same trades at the same time.

Envisioning a New Kind of Hedge Fund

Many hedge funds employ fairly standardised strategies to make their money, such as merger arbitrage or convertible bond arbitrage. And while each individual manager will pursue his or her strategy as best they can, it’s easy to envision a passive, rules-based way of trading on some of these strategies. This passive strategy that would act as a baseline for expectations about what a manager should achieve just for focusing on a particular corner of the market, irrespective of their own particular genius.

In the case of convertible bond arbitrage, for example, the passive index would buy all convertible bond issues that conformed to certain characteristics like size or liquidity, and short the common stock of each issuer. For merger arbitrage, the passive index would buy a basket of companies that were the targets of announced transactions, and short the acquiring companies, without trying to pick out the best deals.

Once such a strategy is envisioned, it follows that it should be investable through a vehicle such as an exchange traded fund (ETF), to service those investors looking for a low-cost way of accessing some of these well-known trading strategies. To be sure, a number of ETFs have been launched in recent years to provide investors with hedge fund-like exposure. (In a prior article, “Hedge Fund ETFs Under the Microscope,” we examined some of the pros and cons of a series of these products.) But in Europe these have tended to be designed to give investors exposure to the net returns of actively managed hedge funds.

The Current Breed of Hedge Fund ETFs

For example, in the case of the Goldman Sachs Absolute Return Tracker (GAQ1), exposure to hedge fund returns is accomplished through a replication or ‘cloning’ process, whereby the ETF goes long or short a series of financial instruments chosen not to mimic what hedge funds are investing in, but rather to statistically approximate the characteristics of the historical net returns from hedge funds. In the case of ETFs such as db x-trackers db Hedge Fund (DX2Y), RBS Market Access CTA Index ETF (M9SX), or UBS ETF HFRX Global Hedge Fund SF (UIQA), the point is to provide exposure to an index that is comprised of actual hedge funds. In none of these cases do investors in the ETF get access to hedge fund returns without the famously high fees netted out.

Instead, an ETF tracking an index that actually traded the same instruments as hedge funds, according to the same strategies, would more closely approximate the relationship that exists between passive and active funds in the traditional long-only space. The passive execution of a strategy would have some return stream associated with it, and whereas in most cases investors currently pay hedge fund managers “2&20” on their entire profit, some of it may well be beta to the generic returns from their strategy and only part of it the manager’s unique alpha on top of that.

A New Way to Evaluate Hedge Fund Managers

What we would get from a passive hedge fund ETF is not only a low-cost way of accessing the asset class, but also an investable benchmark for evaluating hedge fund managers within certain strategies. That should have the effect over time of bringing down fees on active funds, which seems to have already started through a combination of competitive pressure, poor performance, and a growing feeling amongst investors that many funds aren’t giving them value for their money. After all, in many cases the performance fees that hedge funds currently charge are levied on all profits above the risk-free rate, which is selected as the bogey precisely because the manager claims there is no accurate benchmark that would better serve as a hurdle rate. A series of passive benchmarks would create exactly such a bogey.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Alastair Kellett

Alastair Kellett  is an ETF analyst with Morningstar Europe.

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