Special Report: ETFs and Hedge Funds

Stockholm (HedgeNordic) – Hedge funds and Exchange Traded Funds (ETF) at first sight may appear far apart and impossible to compare or even find common ground in the investment universe. It seems like comparing apples to oranges But this prejudice is being challenged.

When talking to hedge fund managers and allocators in the Nordics, it has become increasingly clear to us that ETFs have become a much more accepted way of gaining market exposure. This trend is likely to be enhanced by the proposed retrocession ban on fund distribution in Sweden, and put pricing pressure on both the mutual fund and hedge fund industry. The entire discussion on pricing practice of hedge funds took another dimension in the summer, when California Public Employees’ Retirement System (CalPERS), the largest pension fund in the U.S., and one of the first pension funds to invest in hedge funds in 2002, announced that it would pull all US$4 billion invested in hedge funds, due to high cost.

In addition to that, passively following an index, what most early ETFs did, seemed to be a good idea. There are plenty of studies around suggesting that only a fraction of active fund managers manage to outperform “the market” i.e., the index regularly. As an example, the S&P Dow Jones team looked at 2,862 mutual funds that had been operating at least 12 months as of March 2010. Those funds were all broad, actively managed stock funds.

The team selected the 25 percent of funds with the best performance over the 12 month period through March 2010. Then the analysts asked how many of those funds in the top quarter for the original 12 month period — actually remained in the top quarter for the four succeeding 12 month periods through March 2014. The answer was a vanish- ingly small number: Just 0,07 percent, or two of the initial 2,862 funds managed to achieve top-quartile performance for that five successive year period.

It seemed pretty straight forward then that investors are pouring into tools that can provide market Beta at very low cost. There was also a convincing logic splitting investment pools into Alpha and Beta pots. Beta was achieved through ETFs in portfolios, while hedge funds and other alternative investments were used for excess returns, or Alpha. So, it all made sense: mutual funds will disappear, while hedge funds and ETFs will share the 80 trillion or so Dollars invested globally in investment vehicles. The borders were clearly drawn along lines such as active and passive, Alpha and Beta.

Or are they? There are many areas where hedge funds and ETFs meet. In this paper, we try to identify how hedge funds make use of ETFs and how ETFs in return can actually benefit the active investor and the fact that there is today an increased interest for active ETFs coming out of the US where for example hedge fund strategies are replicated through ETFs.

We invited industry experts like ETFGIs Deborah Fuhr, and PWC for an overview of the global perspective and discussed challenges and opportunities ETFs are facing with Fiona Moore, Northern Trust’s Head of ETF Fund Administration Europe, and show on two examples how ETFs make use of „hedge fund“ skill.

We also aimed at getting a Nordic skew into the paper, and had the opportunity to get insightful data and expertise from Nasdaq Stockholm, interviewed Swedish pension fund AP3s Hans Ericsson on how he uses ETF for efficient market exposure, and how the Swedish hedgefund eTurn uses ETF in their tactical asset allocation. With Deutsche Asset& Wealth Managements Erik Rotander and Geir Epeskog of iShares Blackrock we have the Nordic representatives of some of the world’s largest ETF providers discussing where hedge funds and ETFs meet and what the key drivers for institutional demand are.

To download the report free of charge, please click here: ETFs & Hedge Funds

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