August 2008

ALTERNATIVES: ETFs & An Uneasy Alliance

ETFs have given investors simple access to a wide range of assets. But private equity and hedge funds are proving a challenge for providers, reports Angele Spiteri Paris ... With an investor-friendly structure and competitive fees, exchange-traded funds (ETFs) seem like the ideal way to gain access to alternative sectors like hedge funds and private equity. However, the very nature of these two asset classes, particularly with their notorious opacity, may demand compromises that no ETF provider is willing to make.

The success of ETFs in offering access to a wide range of investments means that it was inevitable that providers would push the boundaries and look to adapt the ETF structure to more exotic asset classes.

But hedge funds and private equity are diametrically opposed to ETFs in terms of their characteristics. On the one side there is secrecy in hedge funds and private equity, while on the other side are ETFs with their open structures that allow cost-efficient, liquid and transparent exposure to various asset classes.

Providers within the ETF market have expressed enthusiasm for these new vehicles, claiming them to be a means of bringing alternatives to the masses.

But certain investors have expressed doubts.

A private affair
Gaining access to pure private equity returns through the ETF structure is difficult at best. “ETFs democratise whatever market they represent, taking out all of the complication,” says William Rhind, head of sales at ETF Securities. This statement could not be more true of private equity ETF vehicles, in that they are a simplistic representation of the asset class, synthesising complex private equity deals and confidential information into a tradable tool made up of equities.

Private equity ETFs that have been launched generally hold the 25 to 30 biggest names in the S&P Listed Private Equity Index. The index is designed to provide tradable exposure to the leading publicly listed companies in the private equity space. But views are split as to whether ETFs built on this premise provide legitimate access to the returns of the asset class.

John Finn, a consultant at Hewitt Associates, a pension fund advisory firm, says: “The exposure to the 25 biggest names in the industry might not be the exposure you actually want. It is true that you get exposure more quickly, but it offers the said exposure in a very limited fashion.”

Similarly, Nicola Horlick, chief executive at Bramdean Asset Management, believes there is no substitute for direct investment if one wants to tap into true private equity returns.

“Investing through funds is the only way to get actual exposure to this asset class,” she says. Horlick explains that in a private equity fund, the manager would have negotiated his way into the best deals and this results in returns that cannot be replicated by an index or an ETF.

Robert Brown, chief executive at Pan Asset Capital Management, is more positive and notes that private equity ETFs allow investors to make a bet on the asset class without suffering from the drawbacks included in direct investment.

“I think it’s difficult to say the 25 biggest listed companies are not representative of the industry as a whole,” Brown says. He explains that if an investor were to invest directly in private equity, although it would be possible to find an outperforming  fund or manager, overall these 25 or so firms should reflect the success of the private equity arena.

Hedging forward
Creating a similar vehicle for the hedge fund space has been proving more difficult. This is because hedge funds and ETFs are far from the ideal marriage. As yet no hedge fund ETFs have been launched, but some providers indicate their interest.

Under the UCITS regulations, funds are now allowed to track hedge fund indices and therefore the natural progression is for providers to structure an ETF linked to a hedge fund index, such as FTSE’s hedge fund series.

Manooj Mistry, head of equity ETF structuring at Deutsche Bank’s db x-trackers, says: “I think it would be an interesting product to have. Clients always ask whether a hedge fund ETF will be created and my answer to that would be not immediately.”

There are a number of difficulties with creating ETFs linked to hedge funds, many  of which stem from the nuances within the UCITS rules, as well as the very nature of the underlying assets themselves.

“Under the UCITS guidelines, there are several specific requirements that need to be adhered to,” notes Justin Egan, senior consultant with Carne Global Financial Services. He explains that due to these requirements, although there currently are a number of popular hedge fund indices, they may not be sufficient to allow a Ucits ETF to be built on the back of them.

“According to regulation, being well known is not enough,” Egan says. “There has to be a certain level of liquidity and price reliability underneath the index, as well as some other criteria, before it can be considered robust.”

ETFs thrive on liquidity and transparency, two descriptions that cannot in any way be attributed to hedge funds. An ETF is priced every day, but if the underlying hedge funds calculate their net asset values (NAVs) weekly at best, then the resulting ETF will not be truly transparent.

The other major gripe with the attempt to launch ETFs in the hedge fund space is the nature of the very indices they would track. Hedge fund replicators and indices have been a contentious topic ever since they were mentioned a few years ago because of doubts about whether hedge fund returns can ever be truly reproduced.

Axel Lomholt, head of ETF products for iShares Europe and Asia, comments: “It is very difficult to replicate hedge fund returns. There are many ways you can do it. For example, you can build indices that replicate hedge funds. However, it is difficult to say whether these are true hedge fund returns.”

Hedge fund indices attempt to include data for a large number of hedge funds, but they have been criticised for not having a broad enough scope given the sheer number of hedge funds out there. The argument for hedge fund ETFs hinges on the question of which names they will track and how these are chosen.

“A hedge fund ETF may very well be transparent, but it would only be tracking, maybe, 100 names,” says Finn, at Hewitt Associates. “There are still 9,000 names out there that this ETF is not tracking and therefore this will not give an accurate picture of the asset class as a whole.”

Also, the 100 names included in the ETF may not be the ones an investor would want to invest in.

Horlick, at Bramdean Asset Management, says: “Only a select band of people are allowed into the very best hedge funds. A lot of these are never going to be open at all. So putting something you can’t actually buy into an index doesn’t make a great deal of sense.”

All the signs point to many compromises having to be made for hedge fund ETFs to be created. If they were to find a foothold, the likelihood is that the resulting structure would be very different from traditional ETFs.

“At the end of the day, its all about liquidity and access,” says Mistry of db x-trackers. “You have to be able to create something that’s transparent and easy to trade. Investors want to make sure they are buying something at the right price and not at a big premium or discount.”

He revealed Deutsche Bank is currently trying to solve the hedge fund ETF conundrum. “It is not an easy one to solve,” he says. “We need to take all the different considerations into account and try to create something that will work.” He adds that the concept is still in the development stage and therefore he could not give further information.

Confusion diffusion

ETFs have been successful and are targeted at institutions and individuals. Brown, of Pan Asset Capital Management, says hedge funds ETFs should be treated with caution. One wrong move on behalf of providers could reverberate across the whole slew of ETFs and mar the robust reputation they have built up. If one of these new vehicles were to go under and placed in the hands of the wrong investor, the damage could potentially be disastrous.

“If a retail investor puts a lot of  his money into a leveraged ETF without receiving any expert advice and then loses half his money, the story will reflect badly on the whole ETF space,” he says.

Mistry, of db x-trackers, agrees that the difficulties of accessing esoteric alternatives through ETFs must be overcome intelligently. “Anyone trying to create a hedge fund-type ETF must address the challenges that come with it and overcome them to make sure they don’t tarnish the reputation of ETFs.”

In spite of the rife scepticism surrounding the birth of these alternative vehicles, the progression into the space has been deemed almost inevitable.

Lomholt, of iShares says: “Increasingly, people are looking to bring out more advanced structures which reflect the natural evolution of the market. There will be segments that will find this of interest, while others will not.”

But, although these developments are bound to take place, he feels that their take up will not be huge in terms of asset gathering, and that traditional ETFs will still have alternatives in a stranglehold. ©  2008 funds europe

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