Exchange-traded funds (ETFs) have done wonders for investors when it comes to portfolio construction. Not only have ETFs become the de facto building blocks for many core asset classes, but their usage has also moved into more esoteric securities and strategies. Today, you can find everything from preferred stock to commodities tucked inside an ETF. Active ETFs have only expanded this fact further. And now, investors can use strategies and asset classes that have long been the stomping ground of institutions, endowments, and pension funds.
We’re talking about true hedge fund exposure.
State Street has partnered with Ray Dalio, one of the world’s elite hedge fund managers, to bring his proven strategy to regular portfolios. This could be a long runway for other hedge fund managers to launch similar vehicles. Active ETFs and their structures have made it all possible.
True Hedge Fund Exposure
With the diversification benefits of various asset classes diminishing, many investors have been looking for new ways to add diversification and non-correlation to their portfolios. For many larger investors, this has meant a dose of alternatives such as hedge funds.
The ETF revolution brought many of these strategies and asset classes to the masses with liquid alts and so-called hedge fund strategies. For example, NYLI Hedge Multi-Strategy Tracker ETF (QAI) debuted back in 2009.
However, many previous hedge fund ETFs have used replication to deliver hedge fund-like returns. They purchased futures or other ETFs to mimic hedge fund strategies.
But that has finally changed, courtesy of State Street and Ray Dalio.
Dalio’s hedge fund Bridgewater has been one of the largest and most successful asset managers in the space, with $125B in AUMs and years’ worth of double-digit returns. The key to that has been Dalio’s risk parity approach to investment management. Risk parity focuses on the allocation of risk based on volatility rather than the allocation of capital. Bridgewater’s methods are secretive and use computers to develop the models used in delivering its stellar returns.
But this all-weather strategy is now available to regular Joes. Partnering with SSgA, the new SPDR Bridgewater All Weather ETF (ALLW) will seek to use the firm’s risk parity strategy to deliver steady returns across a wide range of market conditions and environments. And just like its hedge fund sister, ALLW has a free range of global asset classes, including domestic and international equities, nominal and inflation-linked bonds, and commodity exposures — both long and short for asset types.
The difference is that the fund is sub-advised by Bridgewater and uses their proprietary models to develop and allocate the ETF’s assets and taps into the hedge fund’s views of cause-and-effect relationships with regard to various asset classes and the market environment.
This is true hedge fund management vs. the replication of a hedge fund index or trying to copycat liquid alts.
It’s All About Active ETF Structure
Bridgewater and State Street’s new fund shows the power of active ETFs and could be the beginning of what’s to come. The key is in the structures of active ETFs.
While there are some exceptions, most ETFs are built using rules under the Investment Company Act of 1940, meaning they are structured similarly to mutual funds. Under that regulation, ETFs were forced to disclose their holdings daily. This helped market makers provide liquidity and keep many funds trading close to or at their net asset values.
That is a major problem for many hedge fund managers. They spend a lot of money on research and keeping their secret recipes, well, a secret.
The SEC heard many concerns from various investment managers and allowed semi-transparent and non-transparent ETF structures to be launched. This keeps the secret recipe locked away. For hedge funds like Bridgewater, this is great news and allows them to reach the masses like never before and be a huge area of growth.
It’s a win for investors as well. Aside from being able to tap into hedge funds, investors now get that exposure with some added benefits.
Hedge funds are notorious for their so-called “2 & 20” fee structure. This includes charging a 2% fee to manage the assets and 20% of any generated profits. With an ETF, the fee is lower. For example, ALLW charges just 0.85%, which is slightly above the active ETF average, but still cheaper than a mutual fund or hedge fund.
Secondly, ETFs provide liquidity. Hedge funds often have long lock-up times, with dictated liquidity events. This can make it difficult for an investor — retail or institutional — to sell their holdings. With an ETF, you can buy and sell as you please
Then there are taxes to consider. Many hedge funds are structured as partnerships with K-1 statements and feature plenty of capital gains. However, with an ETF, those gains taxes could be passed through to APs via the creation/redemption mechanism. This means that the ETF could be a very tax-efficient way for hedge funds to be structured.
Just the Beginning
State Street’s and Bridgewater’s new fund could be the beginning of a revolution in active ETFs and big-name hedge funds. The fund has quickly gathered over $125 million in assets in just a few weeks. Moreover, we’ve seen smaller hedge fund managers Clough Capital and Tremblant Capital launch ETFs that use their strategies.
With the active ETF structure providing significant benefits for both issuers and investors, more launches could be in store. Already, Goldman Sachs’ whitelist ETF provider, ETF Accelerator, has reported more interest from hedge funds to “deliver their investment strategies within the ETF wrapper.” We could soon see more hedge fund ETFs from the likes of Blackstone and Ares, or firms like Citadel. 1
The real winner could be our portfolios — with new non-correlated holdings and tax savings, all for low investment costs.
Hedge Fund-Like ETFs
These funds are selected based on their ability to tap into liquid alternative strategies and their assets under management. They are sorted by their YTD total return, which ranges from -7.2% to 1.6%. Their expense ratio ranges from 0.50% to 1.46%, with AUM between $150M to $2B. They currently yield between 0% and 6.6%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| WTMF | WisdomTree Managed Futures Strategy Fund | $185M | 1.6% | 0% | 0.65% | ETF | Yes |
| MNA | IQ Merger Arbitrage ETF | $215M | 2.9% | 1.1% | 0.77% | ETF | No |
| RLY | SPDR SSgA Multi-Asset Real Return ETF | $486M | -1.9% | 6.6% | 0.50% | ETF | No |
| FMF | First Trust Managed Futures Strategy Fund | $157M | -3.2% | 2.1% | 1.01% | ETF | Yes |
| QAI | IQ Hedge Multi-Strategy Tracker ETF | $695M | -4.1% | 2.3% | 1.13% | ETF | No |
| DBMF | iMGP DBi Managed Futures Strategy ETF | $1.38B | -4.9% | 2.9% | 0.85% | ETF | Yes |
| FTLS | First Trust Long/Short Equity ETF | $1.95B | -7.2% | 1% | 1.46% | ETF | Yes |
Overall, State Street and Bridgewater could have a real hit on their hands if the fund delivers on its promise. More importantly, it has opened up the floodgates for additional hedge funds to migrate to ETFs. Thanks to semi-transparent and non-transparent structures, active ETFs could be the wave of the future when it comes to new alternatives in portfolios.
Bottom Line
Hedge fund-like ETFs have long existed, but now, investors may have a true hedge fund exposure. The new ETF from State Street and Bridgewater sets the stage for a potential revolution in active ETFs and hedge funds.
Fn1. ETF Stream (March 2024). Hedge funds look to launch ETFs amid active boom
