ETF Growth: Parallels To Hedge Funds

Maybe there’s something to be said about the fact that there are too many ETFs. According to this column from HedgeWorld:

In the past 12 months 252 new exchange-traded funds were launched worldwide and ETF assets increased globally by 46%, according to research by Merrill Lynch. There now are more than 665 equity, bond, commodity, and currency ETFs, with combined assets of $525 billion.

We’re still far from comparable mutual fund numbers, but the growth is quite staggering. A fairly synchronized global bull market since late 2002 provided nice fuel. A similar pattern in growth can be found at the other end of the investment spectrum: hedge funds. Wikipedia may not be a suitable authority on the hedge fund industry, but the site is quite up-to-date on statistics in general and in this case provides data from a good source of industry information, Hedge Fund Research Inc. From the Wikipedia entry on 'hedge funds':

Assets under management of the hedge fund industry totaled $1.225 trillion at the end of the second quarter of 2006 according to the recently released data by Hedge Fund Research Inc. [HFR]. This was up 19% on the previous year and nearly twice the total three years earlier. Because hedge funds typically use leverage/gearing or debt to invest, the positions they can take in the financial markets are larger than their assets under management. The number of hedge funds increased 10% during the past year to reach around 9,000 according to HFR.

Hedge fund data is notoriously opaque in nature so don’t consider the data above as “hard numbers”, but you get an idea of the scale involved in terms of size and growth. On the one hand, you would think that the strong bull market over the past 4 years would explain the ETF boom -- but not the hedge fund boom. However, perhaps with such great returns (aside for the hiccup this summer), comes increased risk taking. Thus, the assertion by many that hedge funds are not so much a “defensive” instrument meant to truly hedge certain risks from a portfolio but are “offensive” to enhance overall returns.

Hedge funds are extremely diverse. Some are meant to provide low volatility. Others are the opposite. So it’s critical to know what you’re buying. In a way, there’s nothing different in this one aspect from knowing the differing characteristics of a bond ETF versus an emerging market ETF.

I can’t say yet that I am overly concerned about the growth in these two areas, although there has been some talk in recent years of a bubble in the hedge fund industry. Despite my lack of overall concern, I would say that having too many funds in a particular area does cause me some unease. For example, how many energy sector ETFs or large cap US equity ETFs do we really need? Similarly, there are a lot of US equity long-short hedge funds competing against each other with surprisingly (or maybe not so surprising) high amount of overlap. What I do like however, is the idea of new ETFs and new hedge funds finding new areas to explore. These new areas may even overlap amongst the ETF and hedge fund entities. For example, the area of carbon trading (a recent article of mine covered this) could be structured in the form of an ETF even as a growing number of hedge funds begin trading them in an opportunistic fashion.

Further to the above, what follows are some further observations with many references to the terms “beta” and “alpha”. Risk and return go hand in hand. Think of beta as the risk/return associated with the movement of the market. Think of alpha as the risk/return associated with deviating away from the market (i.e. active management):

1. Having too many ETFs in the same space is not a very big concern. Those that are not accepted by the market simply get shut down voluntarily. This has happened here in Canada as well as in the US. I’m sure it has happened in most countries with a substantial ETF market.

Too many hedge funds in the same space - a whole other story. In the best scenario, competing hedge funds in the same or very similar underlying strategy simply realize that their efforts in a saturated market are not worth it in an economic sense and shut their fund down. Nothing different here than in the similar ETF case. In a more dangerous scenario, hedge fund managers strive to push on and beat the competition. This can include the application of leverage to “supercharge” returns. Of course, this also brings the potential for “supercharged” risks and is the reason why leverage is almost always the main factor in sizable front-page blowups. As well as hubris. Let’s face it: The hedge fund industry is considered to be the elite of the industry. Top tier education. Track record of performance from sandbox to current YTD returns. Massive bling as proof of past success… and hopefully not as a result of fraud as in a few scary cases. If performance fees are not enough of an incentive, then simply a long history of success provides the drive or arrogance to continue on. It makes the fall just that much greater and some Nobel prize winners (awarded in 1997) from the LTCM blowup (of 1998!) are probably the best example of this.

2. It should be of little surprise that the concept of beta/alpha separation is being accepted by ALL investor types, both individual and institutional, as demonstrated by the increased use of both ETFs (exposure to beta) and hedge funds (exposure to alpha -- and I’ll get back to this point in a minute).

With investors becoming more knowledgeable, one area of concern has been the costs embedded in mutual funds. Management fees are fine, but not when the vast majority of a fund’s return is dependent more on beta than alpha – recall my definition of alpha as 'the risk/return associated with deviating away from the market' and then think about your mutual fund holdings. Hopefully, they’re not closet indexers.

Getting back to management fees, they are often considered a form of “negative alpha” since it is a factor determined by the fund manager/sponsor that negatively affects returns. So, instead of holding mutual funds, a well accepted alternative is to hold a combination of ETFs and hedge funds. For example, if you have a variety of mutual funds for US equity exposure, this could be replaced by a broad and inexpensive US ETF like VV, VTI or SPY. Overlaid on this would be a portfolio of hedge funds that would presumably be beta-neutral, in other words provide only alpha with no beta. This last assumption is rather unrealistic, but even if close to beta-neutral would at least align the portfolio better in terms of performance attribution and aligning fee structures (low for beta, higher for alpha) in a more appropriate manner.

3. Point #2 above generalizes ETFs as a means to beta exposure and hedge fund as the means to capture alpha. A third area of massive growth is in the use of derivatives. This is subject of a whole other blog entry, but it’s key to note that derivatives are a key component to both beta and alpha. Large institutions use swaps and futures instead of comparable ETFs for various broad market exposures/hedges due to the even lower costs. But of course, the use of ETFs is still an integral part of the process. In the past, I’ve mentioned the Yale Endowment (as have many others) and their significant use of alternative investments but there’s very little discussion of them in regard to beta exposures and specifically the use of ETFs. I recently discovered a site via the Kirk Report that lists some holdings from various “Pro Portfolios”. You’ll note some familiar ETFs in the list of Yale’s holdings. Hedge funds implement macro decisions and often apply the use of leverage through the use of various derivative strategies. In this case, the main selling point is not the low costs of derivatives but the massive liquidity available 24/7.

4. Although the concept of beta/alpha separation is relatively new to individual investors, but not so in the institutional investment industry, the concept can become quite blurred. The previous discussion on derivatives is one example. In my recent posting Can Retail Investors Profit From Hedge Fund Access?, I described how the ETF world is starting to evolve as greater levels of active management creep into this space. First we moved away from classic market cap weighted indexation to various alternative forms of indexing. Now we see ETFs allowing for private equity exposure.

Hedge funds traded on an exchange are the next step - although not technically an ETF these really are funds that trades on an exchange so the term does make sense… semantics really. If this trend continues, ETFs will no longer be an instrument for broad market exposure more associated with the concept of beta.

5. (Still with me?) Point 4 ends with ETFs moving from the beta world to the alpha world. I’ll confuse things further by letting you know that a new area of increased research in the academic world surrounds the replication of hedge fund returns using various passive exposures. The removal of active management from hedge funds?! First ETFs moving to alpha … now hedge funds built from beta! What is this world coming to? The end of bling? Relax, this is mainly in the research stage with very limited application in the real world as far as I’ve seen. Rest assured, there will always be a search for alpha. An industry built on fees based on competition and success within that competition revolves around a scarce commodity. That’s alpha.

6. In another previous posting, I discussed how the use of ETFs in a variety of creative ways, and especially through the use of inverse ETFs, allow investors to turn their portfolio into more of a “hedge fund”-like vehicle. As noted in my top-most link, the author from HedgeWorld.com notes that “Hedge funds are heavy users of ETFs, whether for the purpose of hedging positions or as a way to get easy exposure to a market.” Again, some blurring here of the beta and alpha worlds. However, in reality there’s nothing new here. Hedge funds have been trading beta exposures for the exact same purposes by way of derivatives for decades. All I’m saying in my post from earlier this summer is that the ordinary investor can trade beta in the hopes of capturing alpha.

I want to return back to point #1 above, where I mentioned briefly investor concerns of how mutual fund returns are dependent more on market returns versus the skills of the fund manager. Investors seem to be turning to ETFs as the low cost alternative where returns are very similar to the vast majority of comparable mutual funds. I also commented on hedge funds providing investors exposure to alpha, this being returns not associated to the oscillations in the capital markets but as a result of actions taken by a fund manager. But I said “hopefully”. This comment was made because greater evidence has been found, especially in more recent measurement periods, that hedge fund returns also have significant levels of beta. This is an even worse predicament as that found in mutual funds. Paying 1% (or whatever is the management fee for your typical mutual fund) for beta when you can get a comparable ETF for a fraction of the cost is bad. Paying 1% + 10% or 2% + 20% (management fee based on assets under management plus performance bonus based on returns over a certain hurdle or benchmark) for beta just plain sucks.

It’s important to note that the level of beta in the vast majority of hedge funds is nowhere close to that of mutual funds. What is of concern is the level of beta exposure in certain hedge fund strategies as well as the trend (potentially increasing). With a relatively low barrier to entry into the hedge fund industry, the amount of available alpha needs to be divided between an ever growing number of market participants. Thus, alpha becomes ever harder to find. For many practitioners, including myself, the exercise of “seeking alpha” is found through the strategic and sometimes tactical allocation of beta. In other words, I put greater emphasis on a certain type of timing (beta timing) versus stock or bond selection.

Truthfully, there is an aspect of securities selection in terms of finding exposure to new areas not covered in existing holdings in my portfolios. As mentioned numerous times in my previous entries, the addition of new positions (ETF or not) is to add a further bit of risk management to the overall program. An example would be my repeated emphasis on alternative energy considering the significant exposure to commodities, especially oil, found in broad Canadian indices. Of course, we adjust allocations when required as the effects of diversification has its limits. But this brings me back to the top and the proliferation of ETFs: A good thing whether you are a conservative buy-hold simpleton; an asset allocator seeking out new corners of the investment space whether it be country, sector or even strategy; or the next hedge fund manager opportunistically seeking true alpha.

The main theme of this piece is the separation and re-combining of beta and alpha. One common term for this is “portable alpha”. It just so happens that a great site, in fact one of the only sites, for more information on this area is from a fellow Torontonian, whose online alias is boldly “Alpha Male”. Here’s his site.