How and Why Hedge Funds Use ETFs

Abstract

The ETF's popularity stems from it being the ultimate “Swiss army knife” among investable instruments. It fulfills many different roles for virtually any type of investor. The evolution of the ETF industry has turned this instrument into a tool specifically suited for the active investor. The ultimate active investor is the hedge fund. There may be various reasons why the ETF and hedge fund industries have grown together, especially in this new century, but one thing is certain: Their continued growth will likely be due to the way these two fund groups work together, not how they compete for the investor's dollar. Portfolios in the form of 401k plans and other wrap programs, “fund of funds” whether mutual funds or hedge funds and other similar actively managed aggregation of funds will likely have increased use of ETFs as the preferred choice of constituent holdings. However, it will be the hedge fund with underlying ETF positions that will be a growing and significant trend for the future. Due to various forces resulting in convergence within the financial services industry, what constitutes this “hedge fund with underlying ETF positions” in the future will apply in a much broader context. In any case, the expanded use of ETFs by active managers will have far reaching ramifications to the asset management industry as both providers and investors try to define the “ETF” and the “hedge fund” in the future.