Exchange traded funds (ETFs) have been wonderful at democratizing asset classes and bringing various strategies to the masses. That includes everything from traditional bond and equities holdings to more complex fare like commodities and even Bitcoin. And thanks to changes in transparency rules, we could see some very complex asset classes available to retail investors.
In this case, we’re talking about hedge funds.
A recent ETF conversion, as well as growing interest at various whitelist ETF issuers, shows that there’s much to gain from hedge fund managers using ETFs as their preferred fund vehicle. At the end of the day, retail investors may now have access to these complex strategies once reserved for high-net-worth investors and institutions.
Non-transparent ETFs Set the Stage
While there are some exceptions, most ETFs are built using rules under the Investment Company Act of 1940, meaning they are structured very similarly to mutual funds. Under that regulation, ETFs were forced to disclose their holdings daily. This helped market makers provide liquidity and keep many funds trading close to or at their net asset values.
Active managers saw this as an issue. Front-running and copycatting a fund manager’s ‘secret sauce’ is kind of a big deal and eliminates the need to invest with a particular fund. As such, the SEC listened to managers’ concerns and allowed various semi-transparent and non-transparent ETF structures to be launched. This kept the fund manager cooking in the kitchen while still providing all the needed ingredients to make an ETF work on the open market.
It’s these semi- and non-transparent structures that have allowed active ETFs to bloom and grow over the last year or so.
Do you know who likes keeping their recipes secret? Hedge fund managers. And ETFs are quietly and quickly becoming a vehicle for their funds.
Back in December, hedge fund manager Clough Capital purchased ETF company Changebridge Capital and has started to package its hedge fund strategies in an ETF wrapper. More recently, a big-time conversion has occurred at a different hedge fund manager.
Mutual fund-to-ETF conversions have quickly become commonplace with traditional asset managers like DFA, Capital Group, and even Fidelity getting in on the act and taking existing mutual funds and turning them into ETFs. Now hedge fund managers are following suit. Tremblant Capital—which has about $1 billion in assets—recently disclosed that it was converting its Tremblant Tax Efficient Hedge Fund into an ETF dubbed the Tremblant Global ETF (TOGA). This follows other hedge fund managers such as Gotham Asset Management, Chesapeake Capital Management, and Ionic Capital Management in ETF conversions or launches. 1
More Hedge Fund ETFs Coming
This could be the start of a real movement. According to European whitelist ETF provider, HANetf, the firm has continued to gain more interest from hedge fund managers to launch products. Whitelist ETF providers do all the heavy lifting and guide a fund from idea to launch. Goldman Sachs’ ETF Accelerator—which is a whitelist provider here in America—echoes HANetf’s statement, saying that “we have seen increased interest among other institutional clients like hedge funds…to deliver their investment strategies within the ETF wrapper.” 2
There are plenty of reasons why hedge funds may want to consider ETFs for their products and why investors may want to be excited.
For fund managers, it provides a new window for growth on the assets under management front. To buy a hedge fund, you often need to have plenty of initial investment capital and be considered an accredited investor. Not so with an ETF. Some brokerage platforms will allow you to buy fractional shares starting at $1. This brings the world of alternatives into retail investor portfolios. This could ignite an asset-gathering boom for hedge fund managers.
Aside from having access to new alternative strategies, investors of all sizes benefit from ETFs’ relatively lower cost structure and liquidity.
Hedge funds are notorious for their so-called ‘2 & 20’ fee structure. This includes charging a 2% fee to manage the assets and 20% of any generated profits. With an ETF, the fee is lower. For example, the newly converted Tremblant ETF is charging just 0.69%, which is slightly above the active ETF average, but still cheaper than a mutual fund or hedge fund.
As for liquidity, ETFs win out again. Hedge funds often have long lock-up times, with dictated liquidity events. This can make it difficult for an investor—retail or institutional—to sell their holdings. Not so with an ETF, which trades on the secondary market, while authorized participants use an ETF’s creation/redemption mechanism, creating liquidity among ETF shareholders.
That creation/redemption mechanism also provides another benefit: tax savings. Many hedge funds are structured as partnerships with K-1 statements and feature plenty of capital gains. However, with an ETF, those gains taxes could be passed through to APs. This means that the ETF could be a very tax-efficient way for hedge funds to be structured.
Early Innings
For investors, the recent conversions, launches, and interest of hedge funds using the ETF structure could be seen as a good thing. We could see firms like Blackstone, Blackrock, Apollo, and Ares migrating their alternative line-ups into ETFs. This could bring the world of private credit, private equity, and various long/short strategies to the masses. However, we still are in the very early days.
In the meantime, there are some alternatives and hedge fund replication ETFs on the market. Many of these track indexes and can provide hedge fund-like returns to a portfolio.
Alternative ETFs
These funds are selected based on their ability to tap into liquid alternative strategies and their assets under management. They are sorted by their YTD total return, which ranges from -7.5% to 16%. Their expense ratio ranges from 0.50% to 1.41%, while they have AUM between $159M to $950M. They currently yield between 1.2% and 7.91%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| FTLS | First Trust Long/Short Equity ETF | $730M | 15.8% | 1.54% | 1.41% | ETF | Yes |
| WTMF | WisdomTree Managed Futures Strategy Fund | $159M | 10.8% | 4.41% | 0.65% | ETF | Yes |
| QAI | IQ Hedge Multi-Strategy Tracker ETF | $612M | 8.1% | 1.85% | 1% | ETF | No |
| FMF | First Trust Managed Futures Strategy Fund | $164M | 1.6% | 2.52% | 0.95% | ETF | Yes |
| RLY | SPDR SSgA Multi-Asset Real Return ETF | $517M | -0.7% | 5.54% | 0.50% | ETF | No |
| MNA | IQ Merger Arbitrage ETF | $467M | -1.4% | 1.2% | 0.77% | ETF | No |
| DBMF | iMGP DBi Managed Futures Strategy ETF | $949M | -7.5% | 7.91% | 0.85% | ETF | Yes |
Overall, non- and semi-transparent ETFs have unlocked the door for a variety of new and exciting asset classes for investors. This includes actual hedge funds. With growing interest and now some serious conversion to ETFs, hedge funds’ exclusivity could be ending. That could be good news for portfolios.
The Bottom Line
ETFs have been wonderful at democratizing asset classes. Now, hedge funds could be coming to the fund type. New conversions and rising interest among managers could bring the strategies and alternatives to retail investors. And there are plenty of portfolio wins if they do.
1 FT.com (May 2024). Tremblant conversion marks growing hedge fund interest in ETFs
2 ETF Stream (March 2024). Hedge funds look to launch ETFs amid active boom