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Hedge funds losing out to much cheaper ETFs in the Gulf

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Gulf family offices are increasingly using simple exchange traded funds to replicate the investment strategies of hedge funds and save on their high fees and transaction costs, with the additional bonus of instant liquidity.

Abu Dhabi royal family office manager Matein Khalid told the Hedge Funds World conference in Dubai yesterday: ‘At least we know every position and can liquidate on a daily basis’.

Capital locked up

Many Middle East investors found their money locked up by hedge funds during the global crisis, and simple ETF products offer a solution. These financial instruments are traded like shares on global financial markets and can be sold at the push of a button.

ETFs generally follow a dedicated strategy and that includes long and short positions, just like hedge funds. Hence a reasonably sophisticated investor can buy a combination of ETFs to achieve the same financial exposure as a hedge fund, albeit not without the expertise of the hedge fund manager.

However, investors have also become skeptical about the value of these managers whose 20 per cent success fees are the stuff of legend. Several presentations at the Hedge Funds World event demonstrated that 80 per cent of managers fail to meet average performance!

Hedge fund bubble

Perhaps this was inevitable in an industry that grew into an enormous bubble by the middle 1990s, making it more and more difficult for a larger number of managers to allocate a bigger pool of funds successfully.

Indeed, there is a good argument that the surviving hedge funds – or at least some of them – must now be able to better deliver that elusive alpha performance, if only because the competition is less and the worst performers have already failed.

However, therein lies another caveat that Gulf investors hate. Hedge funds do, from time to time, actual fail and lose all their investors’ money. This is the Black Swan risk correctly identified by Professor Taleb who also spoke at this year’s Hedge Funds World in Dubai.

His point is that with a hedge fund you can get outstanding performance for nine years and then lose everything and more in the tenth year. He puts this down to rare or ‘Black Swan’ events which unfortunately are only too common and not that rare; indeed if you visit Australia you will find that all swans there are black.

Stars remain

Gulf investors are clearly learning from their experience. But you can still not deny the performance of the star managers like George Soros. Perhaps the King of the Shorts, Jim Chanos is right on China too. Maybe it was just too much to think every hedge fund manager would be this good.

Replicating the basic hedge fund investment strategies with ETFs makes sense. Going short as well as long in stocks, for instance, hedges risk in a falling market. ETFs are very cheap to buy and sell, and their internal management fees tiny by comparison to hedge funds.

But ArabianMoney does see a problem with the instant selling of ETFs. Is this not likely to make the next market downturn more dramatic and deeper than it might otherwise be?

Certainly local investors who think they can trump hedge fund managers and save on fees need to keep wide awake and be prepared to press their exit buttons very quickly.

There is also systemic risk with ETFs as the money goes to a third party that could get themselves into financial trouble that has nothing to do with the underlying asset class. But then nothing in the investment world is without risk.

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Written by Peter Cooper

March 3, 2010 at 9:17 am

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