How Hedge Funds Use ETFs

Eric Balchunas is a senior ETF analyst at Bloomberg, where he has more than a decade of experience working with ETF data, designing new functions and writing ETF research for the Bloomberg terminal. He also writes articles, feature stories and blog posts on ETFs for Bloomberg.com and appears each week on Bloomberg TV and Radio to discuss ETFs. ETF.com recently caught up with him to discuss how hedge funds are using ETFs.

ETF.com: You've recently talked a lot about how hedge funds use ETFs, so I wanted to pick your brain about that. I found it interesting that you said hedge funds have more short positions than long positions in ETFs. Why is that?

Eric Balchunas: Correct; they have $104 billion in short positions compared to $30 billion in long positions.
A lot of people think hedge funds are out there trying to swing for the fences and return 100% every year. But most of them are looking to isolate certain things in the market, whether they're using merger arbitrage, event-driven or long/short strategies. To do the short side of those trades, they’ll use ETFs so they can cancel out the beta of the market and isolate their positions.

Yes, some of the shorting is just straight-up betting against the market. But most of it is this use of the ETFs as a hedging vehicle. It's interesting that the $104 billion worth of short positions is over half of the total short interest in ETFs, so it’s significant.

ETF.com: Which ETFs are they shorting?

Balchunas: Goldman Sachs lists the short positions, and it's exactly what you would think. It's the old-school products like the Sector SPDRs, the PowerShares QQQ Trust (QQQ) and the SPDR S&P 500 ETF (SPY)―all the most liquid ones. They've also started to use the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) now that it's gotten more liquid.

None of the names on the most-shorted list are surprising, but I was surprised a little by the funds that they are long.

ETF.com: Which ones were those?

Balchunas: VWO is a good example. That's the ETF with the most net long among hedge funds.           

ETF.com: You noted Vanguard is the only issuer where hedge funds are net long. That's an interesting pairing, because Vanguard ETFs have a reputation for being buy-and-hold types of investments, while hedge funds have a reputation for being relatively active.

Balchunas: That number is really fascinating to me and it speaks to, in my opinion, Vanguard's wide appeal. Who doesn't like cheap? That's just so universal.

Also, Vanguard may be the only one net-long, because iShares and SPDR have so many really liquid products that hedge funds love to short. On the other hand, Vanguard's products are usually the second- or third-most-liquid in a category, but rarely are they the first.

It says a little bit about the cost-consciousness of hedge funds, but it also says a little bit about how Vanguard still has yet to really break through that liquidity barrier where they become the most liquid of a category.
They're getting there. Vanguard ETFs have tripled in daily volume over the last five years. This is a big development, because if Vanguard starts to get that mass liquidity, it gets bigger fish attracted to it, and that just beefs up the liquidity exponentially.

ETF.com: What ETF is owned by the largest number of hedge funds?

Balchunas: SPY; it's owned by 154 hedge funds. The SPDR Gold Trust (GLD) is No. 2, at 112. GLD is punching above its weight, because it's not the second-biggest in assets or volume. It speaks to the convenience factor of ETFs. You can go get physical gold, but you have to store it and insure it. It's kind of a pain. The ETF comes along, and even a hedge fund would say that it's just easier and cheaper to own GLD.

ETF.com: We talk about hedge funds as a monolith, but they each have very different investment philosophies. Some have claimed that ETFs are dangerous and they wouldn't touch them. Can you tell us about that?

Balchunas: They usually have two complaints. One is on the high-yield debt stuff. They ask, "How can something be liquid when the holdings aren't as liquid?" The other complaint is on the general rise of passive investing creating inefficiencies.

But on the flip side, as we discussed, hundreds of hedge funds use the products, including HYG. Carl Icahn, who's the king of the hedge funds, says, and I'll quote him here, "There is no liquidity"—this is about HYG—"That's what's going to blow this up."

Now, you have 50 hedge funds that hold HYG. So either they don't listen to him, or he has another motivation. Bill Ackman, another big hedge fund manager, also expressed some complaints about ETFs, but that was after a rough year for his hedge fund. You might want to factor that in.

Either way, the hedge fund relationship with ETFs is a layered one. They use them in certain cases; they complain about them in other cases. The term I use is "frenemies."

ETF.com: Do some of them feel threatened by ETFs, with all the alternative ETFs and smart-beta ETFs coming out?
Balchunas: I don't think they feel threatened. Liquid alts—which are hedge fund strategies in passive structures like ETFs—just haven't done much. There are two reasons for this.

One is that when you're doing sophisticated strategies that involve shorting―especially since shorting can be costly, and you have to time it―putting that into a rules-based index might not be the most efficient way to exercise that.

And No. 2 is, when you buy a hedge fund, you're kind of buying the brain of the manager. Where smart beta has really made a threat to active is in the factors. CalPERS is a high-profile example: They fired their hedge funds and employed a factor strategy in-house. That didn't involve ETFs, but it tells you it's possible you could swap out some hedge fund strategies and use factor ETFs in their place.

Smart beta assets are $500 billion. That's real money. So if anything was a threat to hedge funds, it would probably be in the factor area―not the liquid alts. I just don't see the merger arb ETF taking any assets from a real merger arb hedge fund.

Contact Sumit Roy at [email protected].