ETFs seek appeal among hedge funds

Feb 26, 2007 @ 8:09 am

By David Hoffman

PHILADELPHIA — The Vanguard Group Inc., which long has espoused the virtues of buy-and-hold investing, is encouraging hedge funds — which rank among the most frenetic of investors — to invest in its exchange traded funds.

The Malvern, Pa.-based company has assigned five of its 30 salespeople to market its ETFs to institutional investors, which includes hedge funds.

“The effort is in its early stages,” said Martha G. Papariello, a principal with the financial adviser services unit at Vanguard.

Already, however, that effort is drawing criticism.

By encouraging hedge funds to invest in its ETFs, Vanguard is showing that it “doesn’t really care” about what’s best for shareholders and “just wants the assets,” said Daniel Wiener, the Brooklyn, N.Y.-based editor of The Independent Adviser for Vanguard Investors, a monthly newsletter.

Vanguard’s not alone

To be sure, Vanguard is not the only ETF provider courting hedge funds.

State Street Global Advisors — the No. 2 ETF provider with more than $100 billion in assets at the end of January — has people who are “100% dedicated” to serving hedge funds, said Tony Rochte, a senior managing director at the Boston-based firm.

Barclays Global Investors — the No. 1 ETF provider with nearly $250 billion in assets — also has people who focus on hedge funds, said Lance Berg, a spokesman for the San Francisco company.

Neither BGI nor SSgA would elaborate on their efforts.

But the reason ETF providers are going after hedge funds is clear.

“If you want serious volume, this is your market,” said Charles “Chip” Roame, managing principal of Tiburon (Calif.) Strategic Advisors LLC.

That’s important, because in the minds of many market participants, volume equals liquidity, and liquidity is “free advertising” for ETFs, said Daniel P. Dolan, who markets the Select Sector SPDR Trust ETFs.

Maybe so. But courting hedge funds has its dangers.

For Vanguard specifically, there’s the danger that it could appear to be turning its back on the buy-and-hold principals upon which it was built.

“John Bogle must be quaking in his boots,” said Geoff Bobroff, a mutual fund industry consultant in East Greenwich, R.I., in a reference to Vanguard’s founder. “It seems somewhat out of character for the firm.”

Mr. Bogle did not return telephone calls seeking comment.

Vanguard’s Ms. Papariello downplayed concerns about any damage to its reputation the company might suffer by allowing hedge funds to invest alongside retail investors in its ETFs. The structure of ETFs, she said, allows long- and short-term investors to coexist peacefully.

Risks ahead?

Although it’s difficult to find anyone to disagree with that, some industry observers worry that the hedge funds eventually will find a way to game the system. Particularly vulnerable, they say, are the more narrowly focused ETFs.

For example, a hedge fund could short the basket of stocks held by such an ETF without actually having to buy the ETF, said C. Michael Carty, principal of New Millennium Advisors LLC of New York.

Such a strategy — while very unlikely — could be very disruptive to the ETF, said Mr. Carty, who is developing a hedge fund that invests exclusively in ETFs.

Vanguard doesn’t have such narrow ETFs, but several industry executives said that all ETF providers could get tarred if there is some sort of scandal regarding an ETF.

In fact, such a scandal is one of Ms. Papariello’s greatest fears, she said.

For the most part, however, industry experts said the presence of hedge funds in the ETF market is positive.

Strong volume created by hedge funds helps keep an ETF’s spread to its net asset value as narrow as possible, said Herb Blank, founder and president of QED International Associates Inc., an industry consulting firm in New York.

Light volume can result in wider spreads and arbitrage opportunities, he said.

“They do provide liquidity, and liquidity is always good,” said Herb Morgan, president of Efficient Market Advisors LLC of San Diego. “I can’t see them being disruptive in the ETF space.”

That’s why Vanguard’s decision to court hedge funds is a good one, Mr. Roame said.

Whether it sticks with it or not is another question, he said.

“It will come off as an opportunistic, capitalistic thing to have done,” Mr. Roame said. “I don’t know if they will stay in that business long term.”

Good or bad, Vanguard is unlikely to bolster its efforts to court hedge funds.

That’s because the hedge fund industry’s share of the ETF pie is shrinking, while the retail investor’s share is growing, Ms. Papariello said.

Industry experts agree, although they don’t see hedge funds’ importance to the industry diminishing, because their activity results in volume.

That can be a problem for new entrants into the ETF market, because without volume they are perceived as being less liquid and thus less attractive, said Mr. Dolan, Garden City, N.Y.-based director of wealth management strategies for ALPS Distributors Inc. of Denver.

It’s a Catch-22, and it’s the reason why there is such an advantage to being the first-of-a-kind ETF out of the gate, he said.

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