We Need ETF-Based Hedge Funds

Date: Friday, November 21, 2008
Author: Carl T. Delfeld, Seeking Alhpa.com

As hedge fund titans face an intense grilling by Congressional committees and thousands of hedge funds around the world are closing their doors, perhaps it is time to consider a new approach. A hedge fund structure offers investors many advantages such as maximum flexibility but the model is sure to change under all the heightened scrutiny.

After specializing in country-specific ETFs since 2002, I am considering going out to raise seed capital for a fund focused on deeply discounted Asian and emerging markets with a new structure that addresses some of the current drawbacks of hedge funds, namely; liquidity, transparency, leverage, risk management and fees. By using lots of cash, trading short-term country ETFs and selective use of inverse ETFs, we have managed to be up so far this year.

From the perspective of investors, a lock up period of one or two years is a big problem, especially in volatile markets, and when the fund's investment strategy is not fully clear.

Another issue is the liquidity of the fund's investments. Is the fund able to sell investments to meet withdrawal requests? And if markets move against a fund holding, can it be liquidated without a severe loss?

Investors in hedge funds usually have only a vague idea of what investments the managers are making. The argument for this is that managers fear that their competitive position would be eroded if holdings were made more transparent. One benefit of hedge funds is their ability to use leverage in their investments but the investor may wish to see some limits. Excessive leverage can lead to a disaster if markets move the wrong way. From their beginning, a key benefit of hedge funds has been to mange risk better by hedging risks with the goal of making money in both up and down markets. But investors are usually in the dark as to what guidelines managers use to manage risk.

The standard hedge fee structure of 2/20 with an annual management fee of 2% of assets and a performance fee of 20% over a certain benchmark is likely to face compression. This must be balanced with the need to have string financial incentives for managers.

The new fund model that I am considering would address all of these issues. I would invest in only country ETF and closed-ended funds offering good liquidity to investors and there would be no lockup period. Investors could see Country ETF allocations on at least a monthly basis. In terms of risk management, the use of inverse ETFs would be limited to 20% of assets, no one country could account for more than 20% of assets, trailing stop losses would lock in gains and limit losses, and the use of leveraged ETFs would be limited as well.

For some investors, illiquidity and lack of transparency is not a problem, but many investors want have a better picture of strategy, risk management and holdings. The industry needs to provide more options.