Will Hedge Fund ETFs Replace Hedge Funds?

Date: Friday, June 5, 2009
Author: Michael Johnston, Seeking Alpha.com

The extent of the damage done by the current recession may not be fully known for years, but already a number of the hardest-hit industries are evident. The U.S. banking sector will never be the same. The domestic automotive industry has been dealt potentially fatal blows (perhaps taking the state of Michigan with it). Real estate investors have seen decades of value eliminated in a matter of months. Will the hedge fund industry (as we know it) be the next casualty added to this list?

Although the hedge fund industry has always experienced a moderate amount of turnover, the rate at which funds are currently closing is astounding. Consider the wave of hedge fund closures in recent weeks:

Raptor Capital Management, run by former Paul Tudor Jones partner James A. Pallotta, recently announced its intention to liquidate the $800 million Raptor Global Fund in the wake of significant losses and investor withdrawals, according to a letter sent to investors this week.
Boston-based hedge fund Noble Partners also announced this week that it is closing two funds due to poor performance this year and a wave of investor redemptions. Teton Partners founder George Nobel manages two Gryfalcon funds, which had as much as $1.1 billion in assets in March but now maintain less than half that amount. The Gryfalcon funds have fallen by approximately 30% this year while many of its peers have posted solid gains.
Pequot Capital Management, a $3 billion firm run by Arthur Samberg, is closing its doors amidst a government investigation into trading irregularities, according to letters sent to investors. Once the world's largest hedge fund, Pequot plans to liquidate its Core Funds, while spinning out its Matawin Fund and Special Opportunities Fund.
Sources are reporting that JP Morgan is disbanding the hedge fund and private equity units of its stand-alone Principal Investment Management Group, reassigning employees from these units to other business lines.
Financial Risk Management's $70 million Diversified Alpha Fund, which was invested in numerous well-known funds including Cerebrus, Citadel, and Fortress funds, has decided to liquidate its investments and return capital to investors.
Deutsche Bank is close to finalizing the closure of its Global Masters fund of hedge funds, which once managed assets of nearly $10 billion. Battered by falling asset values and investor redemptions, the Global Masters Fund has invested capital of only $2 billion by the end of 2008.

"Network TV Syndrome"

These are only a handful of the well-known funds that have closed in the last week. Hedge funds have been shutting down at alarming rates since the second half of 2008, damaging the reputation established by years of excess returns. And they might be close to becoming victims of what I've dubbed "Network TV Syndrome." In recent years, television shows have been cancelled with such astonishing frequency that many viewers are hesitant to commit their time to any new shows, fearing that it will be cancelled once they've become invested.

This of course leads to a vicious self-fulfilling cycle - viewers stay away for fear of investing time in a show they are afraid will fail, thereby increasing the likelihood of an early termination.

Given the rate at which hedge funds have closed over the last year, it appears investors are increasingly hesitant to invest new funds and quick to withdraw at signs of poor performance. This of course leads to asset levels insufficient for funds to implement their often complex strategies (or perhaps asset levels insufficient to make managing the fund worthwhile).

On the Other Hand...

The timing for these hedge fund struggles is interesting. While traditional hedge funds have been dropping like flies, new innovations to the ETF industry have provided a new vehicle for all levels of investors to gain exposure to hedge fund strategies. Earlier this year, Index IQ launched the IQ Hedge Multi-Strategy Tracker ETF (QAI), which employs a "proprietary rules-based investment process that selects components from a wide array of [ETFs] that cover commodities, currencies, stocks, bonds, and real estate." Hedge fund ETFs have several advantages over traditional hedge funds, including:

Fees: 0.75% for ETFs vs. "2 and 20" fees for traditional hedge funds
Manager Risk: Tracking an index vs. trusting a manager (remember Bernie Madoff?)
Minimums: ETFs are available to almost all investors, while hedge funds are exclusive to high net worth individuals
Withdrawal / Transaction Fees: ETF investors can close out positions at any time for only the cost of a stock trade, while hedge funds may implement redemption fees and withdrawal restrictions
Transparency: Total transparency (ETF) vs. near total opacity (hedge fund)
Regulation: ETFs are subject to clear regulations, while hedge funds still operate in the Wild West (little federal oversight)

Although QAI has been slow to attract investor funds, it has an average daily volume of more than 25,000, a relatively narrow bid-ask spread, and was recently trading at a slight premium to its NAV. And Index IQ has grand plans to significantly expand its line of hedge fund ETFs, filing paperwork with the SEC to launch as many as 15 new funds, including:

IQ Hedge Distressed Tracker ETF
IQ Hedge Convertible Arbitrage Tracker ETF
IQ Hedge Dedicated Short Bias Tracker ETF
IQ Merger Arbitrage ETF
IQ Hedge Absolute Return Tracker ETF

Of course, a lot of funds are filed with the SEC but never launched, so there's no guarantee that any of the proposed hedge funds will ever see the market. And of course the launch and subsequent closure of any of Index IQ's ETFs could subject these funds to the same syndrome affecting traditional hedge funds.

Although hedge funds are still a multi-billion dollar industry, it seems that they've been irreparably damaged by the length and severity of the economic downturn, just as ETFs are exploding onto the scene, offering alternatives to traditional investment vehicles.

Stay tuned - if QAI and other hedge fund ETFs are able to attract assets from disenchanted hedge fund investors, we could see a changing of the guard.

Disclosure: No positions