(Repeats to additional subscribers, no change to headline or
By Ashley Lau
NEW YORK, March 10 More client-hungry hedge fund
managers are looking to put their investment strategies to work
in exchange-traded funds, a move that could exponentially expand
their pool of investors but requires them to slash investment
That is a tradeoff many managers of smaller hedge funds are
willing to make, hoping Mom and Pop investors can fuel their
growth. Smaller funds are often less able to attract assets from
large pension funds and institutions that prefer the biggest
hedge funds with billions in assets and long track records.
"It's a matter of access," said Mebane Faber, chief
investment officer at California-based Cambria Investments,
whose global tactical hedge fund was shuttered and reinvented as
the Global Tactical ETF in October 2010.
His ETF now holds some $40 million in assets. He declined to
discuss how much growth that represents over his former hedge
fund, but he has found it worthwhile enough to consider
converting another of his two remaining private funds.
Such moves may become more common because of changes
occurring in the $2.4 trillion global ETF space. Exchange-traded
funds were originally conceived of as passive index-tracking
investments, but more are now actively managed and use
alternative strategies like arbitrage and short selling of
stocks. (Graphic: link.reuters.com/syd57v)
ETFs can be traded like common stock, making them more
accessible than actively managed mutual funds, thus easier to
market for a fund manager.
The U.S. Securities and Exchange Commission is considering a
rule that would allow ETF managers to disclose their holdings
less frequently than the current daily requirement. Several
large ETF issuers have filed proposals to prolong the disclosure
period, but none have been approved yet. Such a change would
make ETFs more appealing to privacy-dependent hedge managers.
Switching to an ETF may not appeal to the biggest, most
well-known and highest earning hedge fund managers, who would
have to cut their fees drastically. Big hedge fund managers
typically charge an annual management fee of 2 percent of total
assets, plus a performance fee of 20 percent of profits. ETF
managers typically charge fees of less than 1 percent.
But cutting fees may make sense for some smaller hedge
funds, allowing them to lure more investors and grow assets.
Most hedge funds require investors to put millions of dollars
into the fund, which limits the investor pool to very wealthy
individuals. ETFs do not have such minimum investments, so they
can attract investors who are not as wealthy.
A hedge fund manager who lowers his or her fees to switch
from a hedge fund to an ETF status may have to more than double
assets under management to earn the same amount of fees.
"It's often the managers who are less well-known or
struggling to attract assets," said John Shearman, chief
executive officer at California-based IV Lions LLC and a
longtime hedge fund consultant. "Some of these managers are
trying to grow their business but struggling to compete in a
hedge fund market that's increasingly dominated by larger
funds," and so they move to the mutual fund or ETF market.
ALTERNATIVE AND ACTIVE GROWTH
Growth in alternative and actively managed ETFs is also
paving the way for hedge funds to make the transition. As of
the end of December, there were 221 alternative ETFs with $11.6
billion in assets, up 28.2 percent in one year alone, according
to data from State Street Global Advisors. Alternative ETFs
include hedge-like strategies including merger arbitrage,
long/short and volatility plays.
Actively managed ETFs, which also include some alternative
strategies, also had a robust year in 2013, with 20 new fund
launches, the largest annual count in the past six years,
according to data from San Francisco-based ETF.com.
"It's only logical that existing hedge funds would try to
move into that space," said John Rekenthaler, vice president of
research at Chicago-based Morningstar. "I'm surprised we haven't
seen more of that given how much money and attention is flowing
into registered funds, ETFs and mutual funds offering
Mark Yusko, chief executive officer at Chapel Hill-based
Morgan Creek Capital Management LLC, who manages funds of hedge
funds only available to qualified investors, sees the ETF space
as ripe for his kind of approach.
"There are so many good strategies that the average person
just can't get exposure to if they're not a qualified purchaser
or a qualified client," said Yusko.
Yusko said he has been in talks with ETF firms about
creating an ETF that would mimic some of his hedge-like
strategies. The active ETF would include traditional investments
in stocks, bonds and cash, as well as some hedging strategies
such as arbitrage, the concurrent buying and selling of
securities to take advantage of price differences, or long/short
investing, which involves hedging securities purchases with
simultaneous sales of borrowed similar securities.
The idea is to bring the institutional model down to a level
where everyday investors would be able to access his strategies
so that "people like my mom can invest in what we do, whereas
she was never allowed to before," Yusko said.
Tax efficiency and lower cost are two key attributes that
make the funds more attractive to retail investors.
Still, hedge fund managers moving to an ETF structure may
have to compromise on some of their strategies. Regulators have
loosened rules governing ETF investments, but there are still
constraints on how they can use leverage or invest in certain
derivatives, illiquid securities and private investments.
Yusko noted, for example, that an ETF would not be able to
invest directly in privately offered securities. It would have
to approach that market through a proxy, such as a master
For some hedge fund managers, one more piece must fall into
place before they move into ETFs. They must get SEC permission
to shield their holdings and strategies from daily disclosures.
Hedge funds often use illiquid securities that are hard to
value on a daily basis, often valued at the discretion of a fund
manager. Publicly traded ETFs must disclose their contents
Using only part of a true private fund strategy could create
a divergence in performance, Shearman said.
"Ninety-nine out of 100 times, you lose something -
something that can't be done in that (ETF) wrapper," Shearman
said, referring to parts of the overall hedge fund strategy that
cannot be replicated in an ETF.
THE WAIT FOR NON-TRANSPARENT ETFs
Several large asset managers, including BlackRock, State
Street, and Eaton Vance have asked the SEC to let them market
actively managed ETFs that would report holdings quarterly
instead of daily. Some in the industry say the proposals may be
approved later this year or early next year.
"We don't want anyone to see what we're doing at least for a
week or a month, that's the rub," said McLean, Virginia-based
hedge fund manager and registered investment adviser Sunil Pai,
whose firm ProForza Advisors LLC is considering putting two of
their strategies into an ETF. "It's part of our edge - we just
can't let it go."
(Reporting by Ashley Lau; editing by Linda Stern and David