One type of fund structure is associated with manager skill, performance fees, opaqueness and illiquidity. ETFs, by comparison, offer a purely formulaic approach, ease of trading and transparency, as well as cheapness.
In fact hedge funds and ETFs have long gone together, though in a slightly different way. ETFs’ flexibility has endeared them to the managers of long-short portfolios, not least because of their historical exemption from the “up-tick” restriction on shorting individual stocks in the US, which reigned from 1938 to 2007, and may yet be reintroduced.
But a number of recent news stories suggest that the two worlds may be combining in a more fundamental way. From db x-trackers’ recent launch of a European-listed ETF investing in hedge funds, to IndexIQ’s hedge fund replicator range, product developers are already hard at work on combining the two types of fund.
Then, if one considers the hedge fund/ETF marriage more broadly, as a merger of active and passive trading vehicles, then Barclays’ recent filing to launch actively-managed ETFs under the iShares banner, reported by Murray Coleman earlier this week, must be seen in the same category.
Finally, today’s reported interest of Blackrock, the leading active US-based fund manager, in buying Barclays Global Investors, the world leader in passively-managed funds, takes the convergence theme to a new level.
What should we make of this? One can see the interest of the hedge fund and active management community in gaining access to a part of the fund management industry that’s actually growing. But if you’re an ETF convert, attracted by the funds’ low fees and transparency, is there a risk that things are starting to move in the direction of greater cost and decreased visibility?
On the face of it, it seems unlikely that anything will happen to the low-cost staples of the ETF market, where there’s significant competition from provider firms and fees should remain low. Where there is ample scope for consolidation is in the quantitatively-driven, model-based sector. Arguably, whatever hedge fund managers may claim, there isn’t a great difference between a hedge fund equity portfolio driven by algorithmic computer models and an passive, model-driven index fund – apart from the “2 and 20” fee scale that the former has typically commanded.
While great prizes await the firm or firms that can combine quant-based strategies and ETFs, there’s still a formidable challenge to overcome in terms of explaining how the models work. Barclays’ SEC filing states only that its active equity ETF “will utilize a portfolio construction and optimization process to select stocks in the initial equity fund which incorporates proprietary investment insights”, while its active fixed income ETF will use a “systematic method that relies on proprietary quantitative models to allocate assets”.
No doubt there will be plenty more information to follow, but will investors buy this? Spa ETF’s Marketgrader funds, which used a fund strategy driven by a rather opaque quantitative model, failed to attract significant interest, and were closed two months ago. ETF investor assets, meanwhile, remain overwhelmingly committed to tradional, cap-weighted index funds. Arguably, amongst the model-driven ETFs only the Powershares RAFI funds, based on Research Affiliates’ fundamental indexation idea, have gained significant traction, and that’s only in the US, and with a basic premise that’s easy to understand.
But, as this week’s news stories reveal, the battle to combine the best of the active management world and the best of the index fund industry is hotting up. Opposites attract, after all.
