Proposed Hedge Fund Charts All-ETF Path

June 18, 2008

Hermosa Capital Management hopes to launch a hedge fund this summer that holds only ETFs, which it says would be a first.

 

Exchange-traded funds have found their way into portfolios of all types of investors, from do-it-yourselfers to consultants and even mutual fund managers.

This summer, however, investors might see something a little different - a hedge fund that only invests in ETFs.

California-based Hermosa Capital Management LLC, a registered investment advisor that manages assets for individuals and institutions, plans to launch the Hermosa Capital Fund LP (HCF). It's designed to implement a long/short hedging strategy that invests exclusively in ETFs, and as far as its managers can tell, it is the first hedge fund to do so, although many hedge funds use ETFs alongside other products and securities.

The fund's managers choose its investments based on a proprietary ranking system that incorporates momentum, returns and relative value.

The new hedge fund would be a natural extension of the managed accounts that Hermosa oversees for its high net worth clients, say its managers. Those accounts rely on the same proprietary system.

The proposed hedge fund's portfolio could contain anywhere from three to 10 different ETFs, selected from a universe of roughly 300 different funds. Interestingly, that investment horizon can include ETFs from anywhere in the world.

But Chris Harris, one of Hermosa's partners, says he typically avoids funds in more illiquid types of markets.

'Hands-Off' Policy

"There are some markets we don't touch because of the issue of liquidity," said Harris, noting that some ETFs trading in Eastern Europe, in particular, have great returns.

But liquidity issues in those same markets can make it difficult to get out when the going gets rough, he adds.

Liquidity is a primary concern, of course, because a hedge fund like the one being proposed needs the flexibility to enter and exit positions quickly. Sometimes, that could involve significantly changing positions within the course of a single trading day.

In general, Harris cites ETFs' ease of use, efficiency and broad coverage as some of their most appealing qualities. Hermosa partner Mitchell Miller also points out that with inverse ETFs available, it is much easier to buy an inverse ETF, rather than take a short position as there are fewer complications, such as no need to make margin calls.

Harris said the firm has seen interest from a broad range of investors, but that the ones who are familiar with ETFs are the most enthusiastic ones, while those who don't understand the products tend toward skepticism. For example, according to Miller, they are frequently questioned on the small number of holdings the fund will invest in by people who do not understand that each ETF can represent a stake in hundreds of companies.

"We (also) received a really strong response from individuals who know about ETFs but who don't really know how to take advantage of ETFs in their own portfolios," Mitchell added.

Specific Expansion Desired 

The strategy's holdings have recently included ETFs covering the energy sector, China, Latin America and South Africa. At the moment, Harris says he'd like to see more ETFs covering Colombia in Latin America, Africa and the Middle East - Dubai and the United Arab Emirates, specifically, and possibly even Iraq.

Hermosa's hedge fund will charge a 2% management fee and 25% of profits as a performance fee. Its minimum investment will be $250,000.

Ryan Tagal, director of Hedge Funds and Alternative Investments at Morningstar Inc., was not familiar with the proposed fund but pointed out that liquidity is a big issue in the hedge fund industry.

By investing in highly liquid ETFs, the fund would be able to unwind its portfolio more easily in the event of a liquidity crunch, he said, noting that liquidity has played a role in most hedge fund blowups.

Tagal also mentioned that investing in liquid, easily accessible investments might be a drawback as well. "[In that situation] you're basing a lot on your model," he commented.

Hedge funds have wide latitude in where they can invest. They're not subject to many of the rules that govern mutual funds. As a result, they can seek outsized returns to help justify their relatively higher fees. They also are known for an ability to invest in harder-to-access or less-liquid markets and assets, and they can build up large cash reserves and/or use a host of hedging techniques. Because of its focus on ETFs, no matter which of these tactics it takes, the proposed Hermosa fund will no doubt be even more heavily reliant on its proprietary evaluation system and the skill of its managers than most of its rivals.

The Morningstar Global Equity Hedge Fund Index, which covers long/short global strategy funds and represents about $69 billion in invested assets, was up 3% for the 12 months ended May 31 and 0.38% year-to-date.

According to the Hedge Fund Association, hedge funds are a $2 trillion industry with more than 10,000 active hedge funds currently in existence.

 

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