ETFs Find Enthusiasm, Wariness In Hedge Funds

Oct 13 2006 | 2:57pm ET

By Kate Mcgregor

When hedge funds first became linked to exchange traded funds, few in the industry believed the marriage would last. While most hedge funds that do invest in ETFs use the index funds to hedge against a specific sector or country, some hedge funds are using the highly-liquid vehicles as the main component of their funds.

Alex Gurvich, managing partner of The Rockledge Group, a hedge fund that invests exclusively in ETFs, explains that one of the advantages of the funds is that they give smaller hedge funds exposure to specific sectors for a minimal investment.

"You don't need a large pool of capital to buy a basket of stocks, says Gurvich. "They provide a low-cost, ready-made vehicle that substitutes [buying a basket of stocks]. You can execute strategies based on these baskets, which were once available only to large funds.

However, this low cost of entry is also among the reasons some question the value of using ETFs in sophisticated vehicles such as hedge funds, saying that they are tailored for retail investors. Because of this so-called retail aspect of ETFs, managers such as Allen Gillespie, principal in the Dallas office of GNI Capital, uses the funds selectively. Gillespie says the firm invests in ETFs in its managed accounts, but is still particular about their use in its hedge fund, GNI All-Cap Hedge Portfolio, a long-biased index fund.

"The attraction of ETFs is that they make certain implementation issues easier to deal with," Gillespie says. "ETFs help speed up the execution of a certain agenda." For instance, they can be sold short to hedge a portfolio of stocks, and they are an easy substitute for futures because they don't require additional registration, he explains.

Gillespie adds that finding an ETF that meets that the firm's criteria for its hedge fund is tricky. GNI tends to restrict its investments to broad-based ETFs such as those offered by State Street Global Advisors' SPDR family. The firm prefers them over Barclays Global Investors' iShares, because their high trade volume makes them well-suited for institutional investors and active hedge funds. "I prefer SPDR to those country shares," he says.

While Gurvich agrees that one attraction to ETFs is that they are highly versatile, he says that most managers are not getting the full potential out of them. "Few people know how to use the value of ETFs," he explains, adding that he and his partners do individual research on each of the underlying stocks in an ETF, which most investors don't bother to do.

Jonathan Steinberg, CEO of WisdomTree Investments, which is backed by hedge fund legend Michael Steinhardt, said the 20 fundamentally-weighted ETFs the firm launched in June and the 10 international funds the firm launched today have "been getting a nice response from the hedge fund community." He dismissed any notion that there is a "retail" versus "institutional" aspect within the funds.

"You could have a security like the SPDR which trades 60 million shares a day and serves the passive investor and the most active hedge fund manager," he said. "Flexibility is inherent in the ETF format. These are tools to be used by different constituents."

Steinberg adds that the rhetoric in the media that the ETF market is saturated often confuses their influence as investment vehicles, especially when one considers that there are 596 ETFs compared to 8,000 hedge funds and 9,000 mutual funds.

While experts may debate the use of ETFs by institutional investors, the data speaks for itself. Morgan Stanley anticipates "strong growth in innovative and alternative investment products including hedge funds, property funds, private equity and structured products," through the year 2011, according to a mid-year report by the firm. The report notes that institutional users of ETFs in the past five years has grown by 251%, going from 448 institutions in June 2000 to 1,571 institutions in June 2005, and forecast continued growth outside of retail investors.

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