ETFs were once seen only as a substitute for mutual funds, but now ETFs are caught in a broader light. ETFs now help investors reach all corners of the financial markets independent of geographical boundaries.
First dominated by HNIs (High Net-worth Individuals) and investment companies ETFs have allowed small investors to enter markets. ETFs, nowadays, is also seen as a cheaper and more efficient alternative to hedge funds which are typically out of reach of retail investors.
According to the US Securities and Exchange Commission
‘Hedge funds pool money, from investors and invest in securities or other investments to get positive returns. Hedge funds are not regulated as heavily as mutual funds.
Generally, they have more leeway than mutual funds to pursue investments and strategies that may increase the risk of investment losses.
Hedge funds are limited to wealthier investors who can afford the higher fees and risks of hedge fund investing, and institutional investors, including pension funds.’
To the casual observer, ETFs and hedge funds might not look similar, but several ETFs look like hedge funds by adopting various strategies.
ETFs cannot directly mirror the hedge funds but replicate their performance using the assets in question.
Some ETF strategies that act like Hedge funds
1. Direct approach
ETFs are highly liquid securities tradeable on the stock exchange. Thus, it doesn’t allow them to hold Hedge Funds since hedge funds are illiquid and come with lock-in periods.
Then such ETFs rely on other strategies to get the job done. One strategy is the direct strategy in which the ETF will directly take positions in the underlying assets needed to provide the promised return by passive management or active management.
ETFs have brought several hedge fund strategies like long/short, market neutral, currency-carry, etc., strategy to the picture.
A long/short strategy is one in which the management has both long and short positions in securities, covering both sides and compensating for any losses.
Managers take a long position in undervalued stocks and a short position in overvalued stocks. A market-neutral strategy is similar to a long/short plan. A currency carry strategy is a strategy that uses a low-interest-rate currency to fund the trade in a high-interest-rate currency.
Similarly, ETFs will use a direct approach; a long/short ETF can directly short the underlying security, buy an inverse ETF, or use a swap agreement with banks. A currency-carry ETF might use currency-forward contracts.
2. Hedge Fund Replication
ETFs, replicate the returns of a hedge fund. Hedge funds are generally very secretive in their work; however, they report their returns to hedge fund indexing firms.
The ETFs then try to replicate these returns with the help of the liquid assets at hand.
Hedge fund replication ETFs attempt to match hedge fund indexes as closely as possible with liquid assets. Liquid assets include things like stocks and bonds, although other ETFs with broad equities or bond exposure is more common.
These ETFs use complex mathematical and statistical tools to replicate such returns. Naturally, since ETFs are more transparent and have to report their holdings daily, the strategy is out in the open!
IM DBI Hedge Strategy ETF and the IM DBI Managed Futures Strategy ETF are some examples of Hedge Fund Replicating ETFs listed in the European markets.
3. Copycat
The third way to replicate a hedge fund is to copy them completely! Hedge funds are by law bound to share their portfolio allocations on a quarterly lagged basis.
Copycat ETFs use this publicly available information to decode the hedge fund’s assets and then base their securities on such assets. These are primarily liquid securities like bonds and stocks.
The largest Copycat ETF is the Motley Fool 100 Index ETF, with an AUM of $532.52 million.
Bottom line is that ETFs cannot fully be hedge funds but can very correctly replicate them.
In an interview given to Morningstar on the launch of ProShares Hedge Fund Replication ETF (HDG), Joanne Hill, Head of Institutional Investment Strategy (IIS) at ProShares, opined that ‘the idea here is that you can take a broad-based index like HFRI, which it captures the performance statistics of about 95% of the assets of the hedge fund industry; it has 2000 hedge funds in it.
So, when you look at that, you can reduce the returns and risk features into six or more tradable factors. So, hedge fund replication seeks to capture these return and risk characteristics, but it does it in a way that you can move in and out, trade it, and see the factors – thus making it accessible to a wider group of investors than available.’
Thus, ETFs have successfully delivered the hedge fund experience to the common masses.
FAQs
What are the top three ETFs?
Ans. Vanguard is the issuer of The Vanguard Total Stock Market ETF (VTI). $271.6 billion in assets are being managed.
State Street Global Advisors is the issuer of the SPDR S&P 500 ETF (SPY). $373.3 billion in assets are being managed.
iShares is the issuer of The iShares Core MSCI EAFE ETF (IEFA).
Can an ETF be a hedge fund?
Ans. ETFs can function like hedge funds even though they cannot possess them. In summary, ETFs are able to implement a variety of well-liked hedge fund strategies, including long/short, market-neutral, currency-carry, merger arbitrage, etc.
What is the best ETF strategy?
Ans. The ETF trading strategies that are best for beginners include dollar-cost averaging, asset allocation, swing trading, sector rotation, short selling, seasonal patterns, and hedging.
