Q&A: Hector McNeil, HANetf
NcNeil discusses whether hedge funds should be considering launcing their strategies in an ETF wrapper, and the benefits of doing so.
AW: Hector, why should hedge funds be looking at ETFs as a possible route to market?
HM: Hedge funds can considerably add to their firepower by launching an ETF. Take the analogy of coffee: manufacturers can bring this commodity to market via a series of different formats, from beans to ground coffee to powder. The same is true for hedge funds: traditionally hedge funds have relied on managed accounts or the offshore fund structure, and more recently UCITS and investment trusts. The ETF can be seen in that context, an additional route to market.
An ETF allows a fund manager to access distribution avenues that you might not otherwise get close to. It’s that simple. We have already seen major institutional investors shifting allocations to ETFs for big parts of their portfolio as they start to recognize the advantages of this structure. Basically, because ETFs available via a stock exchange, all investor types can now access their investment strategies through their brokerage accounts. This effectively outsources ‘Know Your Client’ to the broker who is offering access to the exchange.
AW: Is there a misconception that ETFs are just for massive asset managers?
HM: Building an ETF business from the ground up is a time consuming and expensive business. I should know; I’ve done it. But that is not necessarily a route most hedge funds would want to take into this market. It will take at least 24 to 36 months and cost a minimum of £5-£10 million to establish a European ETF business, not to mention the ongoing staffing and legal costs.
Launching an ETF also involves a steep learning curve when it comes to the specialist architecture involved, the capital markets expertise or the product management and distribution strategies required for success. Beyond that there is the complexity of the European distribution landscape. Many previous market entrants have operated on the basis that ETFs can be sold in the same way as mutual funds, but sadly this is not the case.
AW: Can you launch an ETF cost-effectively, given the barriers to entry?
HM: Compared with launching a fully-fledged, stand alone UCITS, an ETF can be launched quite cost effectively using a white label solution in Europe. A good white label platform will have all the requirements in place for a successful launch, including the necessary regulatory, technological and distribution architecture. The aim is to make the process of launching a full-fledged ETF product onto the European stage as smooth as possible for fund managers who want to access this market. ETFs are a scale business and a white labeler offers “collective” scale through aggregation.
I believe that distribution has to be an important part of this package, given my comments on how selling ETFs to investors is so different from hedge funds or mutual funds. Part of the attraction for hedge funds has to be the potential new sources of capital an ETF strategy can open up for a manager. In addition, many hedge funds will only want to launch one or two ETFs as they are focused heavily on a core strategy. This is ideally suited to a white label approach.
AW: What is an active ETF and how does that suit hedge funds?
HM: Most hedge funds are very active managers and will be asking themselves how an ETF approach to distribution could work for them. It’s a fair point. But an ETF is really just a distribution technology for any investment style or strategy. This is a fast-growing market in Europe and it would be a shame to miss out on this opportunity.
This is an innovative market. While the first ETFs were index-trackers, we strongly believe that within 10-15 years most if not all new fund launches in Europe will be ETFs. They represent a simple wrapper that should not be defined by the strategy that they follow.
Active ETFs are still a small part of this market. They are not properly understood by many in the asset management industry. According to IHS Markit, only 1% of the AuM in ETFs is currently held by active ETFs. That figure will change. We saw 57% growth in active ETFs between January 2017 and June 2018 with 91 new fund launches. While there have already been strong thematic ETF launches, new active ETFs have tended to be from the fixed income space, as many fund managers remain concerned about the transparency that ETFs require, and how this could lead to abuse like front running for example.
Fixed income strategies remain easier to present in an ETF context because companies have multiple bond issues and they are traded over the counter. But the next wave of innovation is going to come from equity managers launching their own active ETFs, and this should include hedge funds.
AW: Won’t launching an ETF mean that everyone will see what the fund is holding?
HM: We are proposing non-transparent ETFs, which may go against the grain for traditional big brand ETF managers, but which we think will still find appeal with investors and hedge funds. We have already seen the growth in the market for ETFs that use smart beta and multi-factor approaches that mimic active fund management. The next logical step in the evolution of the industry will be non-transparent ETFs.
Transparency within the ETF industry does not seem to be the make or break requirement that many fund managers think it is: most investors are happy to see the top 10 holdings in a UCITS fund, for example, not the entire portfolio. Strict regulations governing authorized participants (e.g. under MiFID 2) and contractual obligations mean that it is very unlikely that APs can abuse any privileged information they might receive from an ETF’s PCF files, for example. We are also always re-engineering the ETF industry and we have some really great ideas we want to develop with the right hedge fund partners in this sector.
AW: Are ETFs all about lower fees though?
HM: There has been plenty of publicity recently about ETF managers cutting their fees as they compete for market share. Hedge funds, which have traditionally charged higher fees than mutual funds, may be worried that they will cannibalise their core funds if they make them available on a low fee, exchange-listed format.
The ETF value proposition for many hedge funds is the secret sauce that makes them attractive to investors in the first place, though. Hedge funds are considered to have a unique and specialist knowledge that helps them to outperform the market and for that they should be able to charge higher fees.
AW: Are there any other advantages to launching ETFs?
HM: I am constantly telling potential asset managers and hedge fund providers that ETFs lend themselves best to modern consumerism. My kids will never own a cheque book and won’t want to complete masses of forms. They will want all their investments in once place, easily accessible through their smart phones and amazon prime like responsiveness. Hedge funds and mutual funds will seem archaic to them. Buying something before they know the price and having to sell it back to someone they bought it from, simply will not work. The ETF wrapper is the closest instrument they have that allows them to instantly invest, keep all their holdings at their online broker and move to another broker if they so choose. By offering ETFs, hedge funds can ‘future proof’ their business.
Hector McNeil is the CEO of HANetf, a London-based platform for fund managers that are interested in launching their own ETF products.
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