FactSet Research Systems’ Elisabeth Kashner
Hedge funds and exchange-traded funds have a complicated relationship.
Some hedge funds use ETFs — sparingly — within their strategies, others are taking advantage of the products popularity by serving as market makers, but few are actually trying to get a foothold with new investors by offering absolute-return ETFs of their own.
For example, Bridgewater Associates LP, Millennium Management LLC and Citadel Advisors LLC are among the largest hedge fund operators in the world and occasionally report ETF and ETF option holdings in their 13-F regulatory filings with the U.S. Securities and Exchange Commission. Citadel’s market-making unit, Citadel Securities, has also evolved over the past few years into one of the largest ETF market makers, arbitraging small discrepancies between ETF prices and their underlying securities. The willingness of market makers like Citadel to step into volatile markets is a key part of the ETF ecosystem.
But few hedge funds have jumped the shark to offering their own strategies within an ETF. In fact, the absolute-return category of ETFs — products aiming to produce consistent uncorrelated returns to major asset classes — has accrued just $6.7 billion in total assets across 43 products, the first of which was launched in early 2009. That’s just a drop in the bucket of the nearly $7 trillion U.S. ETF market.
“ETFs that aim to deliver consistent positive performance across market conditions have overwhelmingly disappointed,” said Elisabeth Kashner, vice president and director of global fund analytics at FactSet Research Systems in San Francisco. “Nearly every ETF in FactSet’s absolute returns category has delivered decidedly mixed performance,” she said.
Ms. Kashner adds that many absolute-return ETFs are highly correlated to global equities or to a 60/40 portfolio of global stocks and investment-grade U.S. bonds, running counter to asset managers’ claims of uncorrelated returns. Only three of the 25 hedge-fund-mimicking ETFs have produced higher Sharpe ratios than a simple 60/40 portfolio from the end of 2018 to September 2022, she said.
According to FactSet, absolute-return ETFs include long/short funds, merger arbitrage, tactical asset allocation, global macro and real-return products. Of the 40 ETFs with year-to-date results through Aug. 31, 27 have lost value and longer-term correlations to short-term Treasuries have been negative. “In many cases, investors haven’t gotten the results they might have hoped for from products that commonly cost between 0.50% and 1%,” Ms. Kashner concluded.
A challenging return environment, however, hasn’t stopped investors from directing assets to these strategies. Of the forty-three ETFs tracked by FactSet, six have assets above $500 million, including the $1.3 billion RPAR Risk Parity ETF. (As of June 30, 34.4 million shares were held by wealth management firm Evoke Advisors and its affiliate, Advanced Research Investment Solutions LLC, which built the underlying index.)
“Managing assets within an active ETF is no different than other fund structures,” said Daniel Gamache, Denver-based executive director with Core Alternative Capital. “We find the liquidity and transparency of the ETF to be a distinct benefit to our investors.”
Mr. Gamache is part of the team running the $440 million Core Alternative ETF, which has achieved a 5.9% annualized return over the five years through Sept. 9, according to FactSet data on ETF.com. The annual expense ratio is 1.07% and the fund holds anywhere between 45 to 60 equity positions and short-dated index options. (The ETF has a blended benchmark of 60% S&P 500 index and 40% Bloomberg U.S. Aggregate Bond index.)
“Absolute-return investing can thrive in the ETF structure and its success is an outcome of the investment process implemented every day,” said Mr. Gamache, “not a byproduct of the fund structure it is housed in.”
Michael Green, portfolio manager and chief strategist officer at Simplify Asset Management in New York, also believes in the opportunity for ETFs to capture uncorrelated returns. “Operating within the ETF wrapper, we can execute rebalancing without incurring taxable gains in a manner that is not possible for most individuals and many institutions,” Mr. Green said.
Simplify launched its “permanent portfolio” Macro Strategy ETF in May. With a gross expense ratio of 0.75%, the ETF offers “pass through pricing” that utilizes other Simplify ETFs focused on convexity, volatility and managed futures, as well as index options.
Yet, even Mr. Green admits that there are corners of the market that are slightly out of reach. “We recognize that over-the-counter positions can become risky due to the disclosure,” he said, referring to the requirement that an active ETF must disclose its portfolio positions daily.
Aaron Filbeck, Philadelphia-based managing director and head of UniFi at the CAIA Association, acknowledges that “many traditional hedge funds are investing in less liquid markets and securities” and employ leverage to enhance returns. “In a wrapper that doesn’t mandate daily liquidity, leverage is easier to apply,” Mr. Filbeck said.
While absolute-return ETFs tend to have higher fees than the rest of the ETF market, they are still not as high as the management and incentive fees charged by most hedge funds today.
“High fees are considered a barrier to success for the end investor,” said Simplify’s Mr. Green, but in the hedge fund world, they are a sign of exclusivity. “From my perspective, I’d rather offer investors a great deal and the right structure, especially tax efficiency, and let the numbers speak for themselves.”
