ETFs and Hedge Funds: Separated at Birth

When mutual funds can be cloned using a combination of ETFs and hedge funds, it’s no surprise that both sectors seem to be growing in tandem.  

            

Experts have been trying to reconcile these seemingly contradictory trends.  Are we giving up on active management or embracing it?  Do we want boutique alpha generators or do we want a commoditized solution? 

To be sure, many investors are heading their separate ways.  Efficient market theorists are flooding into ETFs and active management fans are diving into hedge funds.  But we believe this story ends with ETFs and hedge funds living harmoniously within the same alpha/beta portfolios.  

Richard Kang writes a comprehensive piece at Seeking Alpha about the joyous reunion of these long-separated fraternal twins.  In it, he says:

“It should be of little surprise that the concept of beta/alpha separation is being accepted by ALL investor types, both individual and institutional, as demonstrated by the increased use of both ETFs (exposure to beta) and hedge funds (exposure to alpha)…”

Kang makes reference to an argument made often in these pages:

“…instead of holding mutual funds, a well accepted alternative is to hold a combination of ETFs and hedge funds. For example, if you have a variety of mutual funds for US equity exposure, this could be replaced by a broad and inexpensive US ETF like VV, VTI or SPY. Overlaid on this would be a portfolio of hedge funds that would presumably be beta-neutral, in other words provide only alpha with no beta. This last assumption is rather unrealistic, but even if close to beta-neutral would at least align the portfolio better in terms of performance attribution and aligning fee structures (low for beta, higher for alpha) in a more appropriate manner.”

True, it’s tough (or impossible) to find “pure” alpha hedge funds to complement your ETFs.  However, the alpha+beta construct deserves serious consideration since the resulting ETF/hedge fund portfolio may have lower overall fees than the comparable active long-only mutual fund.

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