The Ways ETFs Are Replacing Hedge Funds This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article is by Mike Venuto, co-founder and chief investment officer of New York-based Toroso Investments. This month, Debbie Fuhr’s London-based ETF consultancy ETFGI made headlines with data showing that global ETP assets are now equal to hedge fund assets. It’s important to note that this inflection point coincides with record assets under management for WisdomTree (WETF). For those who didn’t make the connection, WisdomTree has 60 percent of its assets in currencyhedged products that were modeled off of established hedge fund trades. Perhaps the parity reached in the hedge fund assets to global ETP assets can be partially attributed to the role ETFs have played in democratizing exposures that have traditionally only been available to investors willing to pay a 2 percent management fee and 20 percent of their profits with 10-year lockups. With WisdomTree’s success in mind, we got to thinking: What other hedge fund trades are now available through ETFs, and what else could be done in the future? So, we took a deeper look into this emerging ETF category and here’s what we found… First, There Was QAI Let’s review the evolution. IndexIQ, now a unit of New York Life, deserves credit as the pioneer in the hedge fund replication landscape with the launch of the IQ Hedge Multi-Strategy Tracker ETF (QAI | C-56). It took many years, but the ETF is now the go-to alternative ETF for many wire-house platforms and has gathered $1 billion in assets under management. The ETF has consistently outperformed the hedge fund tracking indexes. The irony is that the returns of hedge funds as a whole and QAI are less than exciting for investors, annualizing at around 4.3 percent since inception, although with minimal volatility. To be fair, QAI isn’t designed to knock the cover off the ball. It’s meant to produce fairly reliable, if muted, returns, perhaps a bit like a bond fund.
QAI’s Children But QAI led to a whole set of hedge fund-like products that I call the cherry-pickers. Today there are six ETFs that seek exposure to the top ideas of hedge fund managers. The goal of these products is not to replicate returns but to capture the alpha. For the most part, they have worked and produced excess returns above traditional indexes. Again, the hedging aspect—central to QAI and to hedge funds historically, which is designed to reduce volatility—is absent from most of these products. The AlphaClone Alternative Alpha ETF (ALFA | D-63) is the exception; the index includes a moving average calculation that allows the ETF to take a short position on the S&P 500. Below in the table are a few of these cherrypickers. 'Cherry-Picker' ETFs
Ticker
AlphaClone Alternative Alpha
ALFA
Direxion IBillionare
IBLN
Global X GURU
GURU
Global X GURU Activist
ACTX
Global X GURU International
GURI
Global X GURU Small Cap
GURX
Flattering WisdomTree We noted above that, today, 60 percent of WisdomTree’s assets are now currency-hedged. This trade or exposure has long been a darling in the hedge fund community. WisdomTree has been rewarded for democratizing this exposure with assets and the biggest compliment any ETF sponsor can receive. Deutsche Bank was an earlier copier of the currency-hedging concept. But the arrival in the currency-hedging space of BlackRock’s iShares completely legitimized the currency-hedging concept, even though the world’s biggest ETF company was arguably a bit late to the game. Among those new funds that began coming to market in January 2014 was the currency-hedged iShares MSCI EAFE ETF (HEFA | D-48). It also has strategies focused on Japan, the eurozone and emerging markets.
While this kind of competition may be flattering for WisdomTree, Toroso believes the more interesting news in the currency-hedged space is the newcomers like the AdvisorShares Gartman Gold/Euro ETF (GEUR | D-28). This fund allows investors to buy gold exposure while shorting the euro. We expect to see more currencies paired with commodities in ETFs in the future.
Exposure To Hedge Fund In An ETF? Another interesting concept is to directly invest in publicly traded hedge funds through an ETF. Unfortunately this isn’t yet possible due to two indexing issues. Many publicly traded hedge funds have low floats due to high insider ownership, which makes them difficult to include in ETFs. The best example is Icahn Enterprises (IEP). Carl Icahn owns close to 90 percent of the outstanding shares, which substantially diminishes the liquidity. The second issue is that most publicly traded hedge funds use a partnership corporate structure that is excluded from most indexes because of the tax implications. So, although there isn’t yet an ETF for this space, there is an ETN that owns many of these publicly traded hedge funds. Although investors would never know it from the name, the Etracs Wells Fargo MLP Ex-Energy ETN (FMLP) provides investors access to private equity and hedge fund partnerships. Here are the top 10 index constituents: Hedge Funds
Ticker
Weight (%)
Carlyle Group LP
CG
10.76
Blackstone Group LP
BX
10.73
Icahn Enterprises LP
IEP
9.93
Apollo Global Management LLC
APO
9.68
KKR & Co LP
KKR
9.50
Oaktree Capital Group LLC
OAK
8.87
Lazard Ltd
LAZ
7.99
Och-Ziff Capital Management LLC
OZM
6.75
Brookfield Property Partners LP
BPY
6.64
Ares Management LP
ARES
4.41
Emerging Markets Focus
Another interesting hedge fund exposure is the emerging markets. In general, hedge funds have specialized in the emerging markets to capitalize on growth and inefficiencies. An interesting subset that Tiger Global Management is known for investing in, is the emerging market online consumer. Many hedge funds have been early investors in companies like JD.com (JD) and Alibaba (BABA). The EMQQ Emerging Market Internet and E-commerce ETF (EMQQ) targets companies whose primary business is e-commerce or Internet-related activities that generate most of their revenues in emerging market countries. This is a growth area as demonstrated by the high return on equity and has less than 5 percent overlap to broad-based emerging market ETFs like the iShares MSCI Emerging Markets ETF (EEM | B-97). Cool ETF Frontiers So what’s next? A common trade that many hedge funds are using today is to short, in equal dollar amounts, the leveraged long and leveraged inverse versions of an asset class they expect to be volatile. They are capitalizing on the well-documented phenomenon that in volatile environments the daily reset function of leveraged and inverse products causes erosion of principal. So, for example, if a hedge fund believes financials will do well, it could buy the Direxion Daily Financial 3X Bull (FAS). Conversely, if it believes financials will do poorly, it could purchase the Direxion Daily Financial 3X Bear (FAZ). By shorting both in equal amounts, a third opinion can be expressed: “Financials will be volatile.� This trade has become very popular with hedge funds because it is more efficient than traditional option straddles used to express volatility opinions. But there are a number of drawbacks to the trade. Firstly, the pair will lose money in a low-volatility trending market.
There are also two structural issues. There can be high borrow-cost to short the ETF; and the trading and tax consequences of keeping the exposure balanced can be cumbersome. However, these two structural issues could be mitigated substantially by placing and maintaining this pairs-trade in an ETF structure. What I’m saying is that hedge funds are doing this now, and before long, so will an exciting new ETF. The scale of the ETF structure and the relationship sponsors have with liquidity providers should reduce the borrowing and transaction costs and crucially, the rebalancing process with authorized participants should reduce the tax consequences. This would give ETF investors the ability to express volatility opinions just like hedge funds, but more efficiently. Toroso is excited to watch the success of ETFs grow while democratizing exposure traditionally only available to hedge funds. We believe there is much more to come in this transparent and tax-efficient structure.
At the time of this writing, Toroso clients had investments in ALFA, EMQQ, FMLP and GEUR. Toroso is affiliated with Global X Management Company. Toroso is a New York-based investment advisor focused on researching ETFs and other exchange-traded products and designing asset allocation strategies, using ETFs, which seek to perform well in various economic climates while emphasizing future objectives over past correlations. For more information about Toroso, call 646-545-5195, visit www.torosoinv.com or email info@torosoinv.com. For a list of relevant disclosures, please click here.