ETFs make life hard for stock-picking hedge funds

The proliferation of exchange-traded funds (ETFs) – another of which started trading in Asia today – is making life hard for long/short hedge funds and stock-pickers.

Market performance, or beta, has been a bigger driver of returns since the onset of the financial crisis than the fundamental attributes of individual stocks, say hedge-fund executives. That’s partly because of the wall of money moving into ETFs, which oblige the asset managers that run them to buy shares regardless of their fundamentals, if they’re included in the index that the ETF tracks.

The trend is clear in a white paper published by the Hennessee Group hedge fund consulting company, which shows that poor-quality stocks have consistently outperformed high-quality stocks since the beginning of 2009.

The paper shows that shares rated B- by Standard & Poor’s have had the strongest performance in 2009 and 2010, up 70.1%. Shares rated C – the lowest rating – are the second-best performers, up 65.7%.

By contrast, A+ rated shares are the worst performers as a group, up only 13.4%, with shares rated A up 33.6%.

Peter Douglas, the founder of hedge fund tracker GFIA, says the theme has carried through to Asia, where established hedge funds have been finding life hard. “Smaller managers not relying on experience and going with the flow are performing better than experienced managers,” says Douglas. “The more experienced the managers, the more difficult they have found life.”

The boom in ETFs partly explains this phenomenon. When a stock is added to a major index compiled by, say, FTSE or MSCI, any ETF using that index needs to add exposure to the stock, either by buying it or through synthetic replication. The surge in interest can force up a share regardless of its investment merits.

The outperformance of poorly rated stocks “can be partly attributed to the use of exchange-traded funds as these passively managed funds buy into and sell out of broad-based indices, which leads to erratic moves for the underlying securities, irrespective of fundamentals”, the Hennessee white paper states. “Hedge funds seeking to generate gains in their short portfolios have found this to be an increasingly frustrating development, as stocks with poor fundamentals continue to outperform as they benefit from investor flows into broad-based investment vehicles.”

Although the Hennessee paper is global in scope, the same trends are playing out in Asia, where the bulk of hedge funds invest long/short. “I think quite a few funds have been bitten by beta carry in security investments that they weren’t considering,” says Joanne Murphy, Asia-Pacific marketing director Asia Alternative Asset Partners. “Certain shock factors have come in and surprised them.”

Macroeconomic fears about a double-dip recession in the West and worries about sovereign debt crises in individual markets have dominated the investment landscape. As long as investors continue to favour such a top-down approach, life is likely to be hard for hedge funds and other investment vehicles attempting to pick stocks based on bottom-up analysis.

“The risk-on, risk-off trade, driven largely by macro sentiment, continues to dominate the financial markets,” says Charles Gradante, co-founder of the Hennessee Group. “Until we see fundamentals return to the forefront of investing, we believe hedge funds will have difficulty executing their investment strategy, particularly on the short side.”

Around 55% of Asian hedge funds invest long/short, according to GFIA, though the industry in Asia is slowly seeing greater diversification in terms of strategy.

Douglas notes that the tally is down from a high of 85%, with 2010 likely to be the first year to see more hedge funds launched in Asia that follow other strategies than were launched to pursue long/short investing.

Hedge funds have found it hard to raise capital in Asia this year, with many investors preferring larger managers. Of the $42.3 billion invested into hedge funds worldwide in the first three months of this year, one-fifth reportedly went to three of the biggest managers: New York-based Och-Ziff Capital Management Group; Elliott Management; and the London-based hedge fund manager Comac Capital.

Douglas believes it is getting more difficult for long/short investors to put their money to work because of ETFs and because markets are also in a trend of structural decline in the amount of liquidity in markets, as investment banks shed proprietary trading desks.

“It is much more difficult to run an alpha strategy in a situation where liquidity is ebbing,” Douglas says. Arbitrage plays or a long/short pairing between two stocks in similar industries or sectors may look good in theory, but take too long to come to fruition in those circumstances.

Hedge funds that pursue pairs strategies and market-neutral investing, which have traditionally been some of the most popular approaches for hedge funds in Asia, may need to adjust their approach.

“Those guys will find life very, very difficult,” says Douglas. “I’d like to think most hedge fund managers are reasonably good at being pragmatic and trading as they need to trade. Returns are likely to be lumpier than they have been in the past.”

Separately, the ranks of ETFs offered in Asia are set to swell further. After winning approval from Hong Kong’s regulators, the Value Gold ETF offered by Sensible Asset Management, a joint-venture between Ping An and Value Partners, is due to start trading today.

That will be a solace to Standard Bank which had been accused of jumping the gun in announcing its involvement as a metals provider and market-maker for the fund before the product was approved by regulators in the city.