Because ETFs are so low in cost, it's easy to forget they're not always the cheapest option, especially for largest institutional players.
Sometimes, over-the-counter derivative—including options on ETFs—can be a much more efficient use of capital, says Garth Friesen, CEO of III Capital Management, a hedge fund management company with nearly $5 billion in institutional assets under advisement. Friesen, who has decades of experience in fixed income and credit markets, also authored “Bite the Ass Off a Bear: Getting in & Standing out on a Hedge Fund Trading Floor.”
Friesen will be one of the panelists for "The Hedge Fund Approach: The Smart Money In ETFs," one of the sessions at the upcoming Inside ETFs 2019 conference, held Feb. 10-13 in Hollywood, Florida. ETF.com recently sat down with him to discuss how he uses—or doesn't use—ETFs at his firm.
ETF.com: About how much of your assets under management are in ETFs?
Garth Friesen: Actually, it's a very low percentage—less than 1%. We primarily use them for fixed income and credit derivatives. Usually, we use over-the-counter (OTC) derivatives, interest rate swaps, interest rate "swaptions." We use other credit derivatives as well. We do government bonds, repos, futures, and so on.
It's because we're not a long-only firm; we're not just asset allocators, where we're trying to optimize our exposure in different markets or sectors. From a capital efficiency standpoint, sometimes we're better off in OTC derivatives than in ETFs.
ETF.com: When you do decide to use ETFs, what makes you reach for them over other instruments?
Friesen: We tend to use ETFs opportunistically, where the ETF—whether it's the ETF's liquidity or more nuanced exposure—offers something we can't get in the more leveraged vehicles.
Every once in a while, we'll have a trade that flags the ETFs—whether it's the duration of the trade, how long we plan to hold, whether it's a gamma trade with an option where we'll actively delta-hedge it, and so on.
Most of the time, when we operate the ETFs, it's on the credit side, like with HYG [the iShares iBoxx USD High Yield Corporate Bond ETF]. Every once in a while, we'll use LQD [the iShares iBoxx USD Investment Grade Corporate Bond ETF].
But wherever there's liquidity, we'll often deal in options even more than the underlying. Sometimes the option on the ETF is a better opportunity than the others that are available.
ETF.com: Do you find you end up using options on ETFs more than the ETFs themselves?
Friesen: Yes, though that's more unique to us than the industry. We'll use the ETF if we're trying to do some sort of relative value trade. But given the frequency and flows we generate when we come into the market, we're probably more on the options side than we are the ETF side.
ETF.com: Why do you prefer options instead of the actual underlying funds?
Friesen: One reason is that there's a total return swap market out there that replicates, for example, the exposure of HYG, but we'll only need to post maybe 1-2% margin, instead of 50% or whatever you'd need if you were dealing in the ETF itself. That's so much more capital efficient. And so there's no real capital disadvantage to using ETF options, whereas sometimes there is when using an ETF, compared to other institutional alternatives like swap lines.
Of course, for somebody who doesn't have swap lines, and who can't do OTC derivatives, they don't have any other alternative. But an institutional player who has swap lines at their disposal can sometimes get better capital treatment in the OTC market than the ETF market.
Yes, the total cost of trading an ETF is a lot better than in the underlying cash market, particularly in fixed-income sectors like munis [municipal bonds] and corporate bonds. If your only alternative is cash or ETFs, then ETFs show up as the superior product from liquidity, transaction costs, execution and time to execute.
But if you have the ability to trade OTC derivatives, ETFs can be costlier in terms of not being able to get as much leverage, even if they're lower-cost in terms of bid/ask spreads and the ability to execute electronically.