The liquidity charge

Hedge funds are not typically viewed as major institutional users of ETFs. Yet the ability to utilise them for enhanced liquidity and rapid trading manoeuvres is attracting greater hedge fund uptake, as Helen Fowler reports

On the face of it, hedge funds are not the most obvious users of ETFs. One group is secretive, opaque and expensive; the other transparent, accessible and cheap. Yet ETFs are growing in popularity among hedge funds, which already dominate the $607bn US ETF market. Hedge funds are newer entrants to the $192bn European market, but there are signs their presence is also growing in ETFs on this side of the Atlantic. 

“We see more and more hedge funds willing to use ETFs,” said James Ross, Boston-based senior managing director at State Street Global Advisors (SSgA). “They were early adopters of ETFs, no question, but they have been using ETFs more broadly over the last three or four years.”

Hedge funds own around 50% of the most liquid ETFs in the US market, according to estimates from New York-based asset management consultancy Strategic Insight. They represent up to 90% of turnover in many similar index-tracking products, according to SSgA. 

Even though estimates for hedge fund presence in the European market can be as low as 1%, providers and consultants there report growing interest from absolute return investors. Business from hedge fund clients has more than doubled to 20% in the last six months at ETF Securities (ETFS), according to ETFS head of sales and marketing William Rhind. 

Targeting ETFs

Several global tactical asset allocation funds have reportedly turned to ETFs to achieve their desired market exposures. A Swiss provider is understood to have launched a hedge fund this year invested entirely in ETFs.

“There is more hedge fund usage than two years ago,” confirmed Manooj Mistry, head of db x-trackers UK.

Hedge funds may not be the largest institutional users of ETFs, but they are the fastest-growing category, according to Barclays Global Investors. The number of hedge funds using ETFs rose 14% to 388 from December 2007 to September 2008, accounting for 14% of all users. This increase compared to a 3% rise over the same period for asset managers and private banks, typically the largest institutional users of ETFs.

Hedge funds are exploring the ETF universe for a variety of purposes. The db x-trackers MSCI Emerging Markets ETF, with $2.8bn in assets, is popular with hedge funds which see it as a way of accessing otherwise illiquid markets, said Mistry. 

Db x-trackers is also seeing strong interest in its $400m hedge fund ETF launched in March, which the ETF provider said is the first such vehicle based on actual hedge funds. Mistry explained that there has been interest in the hedge fund ETF from hedge funds using it as a cash management tool for inflows and outflows.

He added: “In the cash markets you are earning interest, but if you are invested in the hedge fund ETF, you get exposure to the hedge fund universe. It’s not as if you are missing out on performance. You are eliminating any potential drag.” 

Short and leveraged ETFs are also especially popular with hedge funds. ETFS’ Rhind said: “Our short oil ETC was one of the most heavily traded in London earlier in the year. A lot of that was hedge funds positioning themselves for a fall in the oil price. Leveraged natural gas has returned 76% over the last month – a lot of funds have been playing that too. ” 

ETFs are also attractive to hedge funds looking to invest in mainstream equity indices, said John Godden, chief executive of London-based hedge fund advisory firm IGS Group.

In the US, hedge funds take a shorter-term approach to using ETFs than other institutional investors, according to Strategic Insight senior research analyst Loren Fox. He said: “High-frequency hedge fund traders use computer-generated programs to jump in and out of liquid ETFs in fractions of a second to capture arbitrage opportunities. Other institutions are more likely to use ETFs longer-term for cheap market exposure or for easy access to niche sectors.” 

Observers of the US market say heavy hedge fund trading is responsible for virtually flat spreads on popular funds. Ross at SSgA said: “That is really helpful to all users of ETFs, not just hedge funds.”

Aware that hedge funds treat ETFs as opportunities for rapid trading manoeuvres, SSgA hired staff with trading backgrounds when it set up its ETF hedge fund sales team in the US a few years ago. SSgA’s Ross said: “We hired someone from the New York Stock Exchange. We wanted people who understood trading.”

ETFs have attractions for hedge funds besides arbitrage opportunities. They can be bought ‘off the shelf’, are transparent and present limited counterparty risk, which Godden from IGS describes as a “very sensitive issue for hedge funds.”

“ETF usage is growing in popularity among hedge funds,” said Godden. “It’s a great new way of getting exposure. Hedge funds are always receptive to new ideas. They are early adopters. The ETF world sees hedge funds as a new and active source of business.” 

ETFs have an advantage over swaps of being traded on an exchange, therefore ensuring they are regulated and  more transparent. 

ETFs also appeal to hedge funds and other absolute return investors who require heavy intra-day trading. Ross at SSgA said: “An ETF is a structure set up to support frequent trading, as opposed to a mutual fund, where you don’t want frequent trading. The rapid trading of hedge funds doesn’t impact the performance of the funds.”

ETFs bolstered by crisis

The credit crunch has boosted the trend towards ETFs. Mistry at db x-trackers said there has been increasing interest from funds of hedge funds following the Lehman collapse, with all the liquidity issues and prime brokers curbing limits.

Unlike futures, which represent one of the most popular alternatives for hedge funds executing trades in large baskets of stocks, ETFs do not present unknown risks which increase over longer time frames. A drawback of futures is that they can require roll-over transactions and involve margin calls. 

Institutions often favour ETFs above the alternatives of futures, total return swaps and traditional index funds, according to the latest Edhec European ETF Survey. The report found: “In terms of liquidity, transparency and cost, ETFs are considered advantageous.” It also said: “ETFs are viewed as making available the widest range of indices and asset classes. ETFs are viewed as superior with respect to the minimum subscription, operational constraints and the relevant tax and regulatory regimes.”

Exchange-traded commodities (ETCs) can offer exposure to assets that hedge funds cannot gain access to in any other way, according to ETFS’ Rhind. He said futures were not a viable alternative to ETCs, “because hedge funds don’t want to be in a position to take physical delivery.” 

Hurdles on course

However, there are obstacles preventing wider take-up of ETFs. Michael John Lytle, marketing director at Source, the ETF provider working in partnership with Morgan Stanley, Goldman Sachs, Nomura and Bank of America Merrill Lynch, said: “Hedge funds are a new and interesting investor base for ETFs, but only for products with real liquidity on the long and short end.”

Hedge funds account for less than 1% of ETF trading volume in Europe, according to Source. Lytle attributed poor take-up to limited liquidity in the European market. He said average daily turnover in the US ETF market was $75bn, compared to $2bn in Europe.

Limited liquidity means it remains expensive to borrow ETFs for purposes of securities lending, which is hindering greater uptake among hedge funds. 

In Europe, lack of liquidity means many hedge funds continue to use futures instead of ETFs. Db x-trackers’ Mistry said: “Hedge funds are using ETFs more in the US. In Europe generally people have been using derivatives longer.”

Mistry said it often remained cheaper for hedge funds to use derivatives, such as swaps, as they are more cost efficient than buying ETFs. Rather, ETFs tend to be a last resort when other options have failed. Mistry said hedge funds will use ETFs when there is no liquidity in the futures market, or the prime broker cannot provide the swap. 

He added he was seeing “much better traction” from private wealth management and fund of fund clients than from hedge fund clients in db x-trackers’ ETF business. 

But as liquidity in the European market continues to grow, hedge funds may increasingly opt to trade baskets of stocks via ETFs. Ross at SSgA said: “I used to look at the European market as being six or seven years behind the US. Now it’s a lot closer and I would expect to see more hedge funds in Europe using these products.” As the ETF market continues to develop, usage looks set to grow among hedge funds. Sometimes the most unlikely partnerships are the most successful.