Complaints aside, ETFs are in hedge fund portfolios

The scapegoating continues.

In his annual letter to investors, The Baupost Group LLC CEO Seth Klarman joined the chorus of prominent investors identifying exchange-traded funds and index investing as a destabilizing force in the modern investment landscape. Mr. Klarman's concerns underscore the challenge that many hedge funds have faced as they try to adjust their models to account for waves of dollars flowing en masse to indexed strategies and away from fundamental investing.

Total hedge fund industry assets grew a slight 0.73% to $3.04 trillion in 2016, according to eVestment LLC, Marietta, Ga. Counterbalancing 2016 investment gains was $106 billion of net outflows, according to eVestment's January 2017 Hedge Fund Industry Asset Flow Report.

On the other hand, global ETF assets topped $3.5 trillion, with funds taking in $389 billion in 2016, according to London-based ETFGI.

Yet the rhetoric belies the fact that many hedge funds have incorporated ETFs into their regular diet of financial instruments for both long and short exposure.

“The relationship? It's complicated,” said Eric Balchunas, Bloomberg Intelligence ETF analyst, about hedge funds and ETFs. “It's virtually impossible to track. Yet, some hedge fund strategies related to ETF trading and the pricing of underlying securities are being oversold. It's just part of the arbitrage that is actually core to the function of ETFs.”

Mr. Balchunas points to the $30 billion in disclosed long ETF positions by nearly 350 hedge funds, with nearly 33% of those holdings by Bridgewater Associates alone. And Goldman Sachs Hedge Fund Monitor estimates that hedge funds" short ETF positions were roughly $104 billion in November.

Previously, the most ardent criticism of the ETF market has been focused on high-yield debt and senior loans, where some believe ETFs are exacerbating a liquidity mismatch. The funds have much shorter settlement times and greater liquidity than their underlying holdings. This particular line of attack has been spearheaded by Carl Icahn and Oaktree Capital's Howard Marks.

And, while some traditionally active managers have opened their views by adding ETFs to their own investing process or exploring ETF and ETF-like product offerings, there remain staunch opponents even in the industry. Peter Kraus, chairman and CEO of AllianceBernstein (AB), New York, whom The New York Times dubbed “The Man Who Hates ETFs,” told the paper in November 2015 that “these funds are free riders and they are not safe.”

“Those who spend their time attacking ETFs fail to grasp that there is no common "index,'” said Mebane Faber, chief investment officer of Los Angeles-based Cambria Investment Management LP, which advises on eight ETFs and $381 million in assets.

“Yes, most are market-cap weighted,” said Mr. Faber, “but many others are now factor-based or fundamental weighted, focusing on small caps, sectors, multifactor, and more. If anything, the reason hedge funds are complaining is that these products can help to make markets more efficient and challenge their model of charging 2 and 20.”

Different weighting schemes push and pull on underlying securities only when there is enough pricing pressure to warrant trading firms, including major investment banks and hedge funds, to close an arbitrage by buying the underlying and shorting the ETF (and vice versa). These imbalances often close within seconds or minutes and are core to the product design to keep secondary market prices in line with NAV.

It's not surprising, then, that most reported hedge fund ETF activity is concentrated in the simplest, most liquid products, including nearly 100 hedge funds reporting holding SPDR Gold Shares, according to Bloomberg's Mr. Balchunas.

“While there are some products that provide access to less liquid asset classes, such as frontier markets, the vast majority of ETF trading occurs in the secondary market with no impact on underlying securities,” says Tushar Modi, director, hedge fund sales for ETFs and indexes at BlackRock (BLK) Inc. (BLK)

Still, argues Mr. Modi, ETF-related trading and arbitrage helps markets set price, especially if others aren't moving. “In the largest, most liquid areas of the equity market, there is no bubble,” said Mr. Modi, and, if there were, he asks, wouldn't hedge funds step in to take advantage of these perceived opportunities?

Even Baupost's Mr. Klarman is optimistic for a resolution in favor of fundamental investing:

“One of the pervasive effects of increased indexing and ETF activity is that it will tend to "lock in' today's relative valuations between securities,” Mr. Klarman wrote. “The inherent irony of the efficient market theory is that the more people believe in it and correspondingly shun active management, the more inefficient the market is likely to become.”

In trading parlance, that's called a setup.