Former Bridgewater Associates executive Bob Elliott’s plan for exchange-traded funds that employ hedge fund strategies has sharpened the debate about whether retail investors should have access to such approaches.
Public open-end mutual funds were created in the 1940s by the United States Securities and Exchange Commission , which forbade or discouraged leverage, derivatives and concentrated positions, making it pretty much impossible to beat the market. ETFs were another SEC creation, designed to protect markets rather than to serve investors. A major problem in the 1987 stock market crash was that people trading baskets like the S&P 500 used futures which settled in a different system and city than individual stock trades. The SEC wanted baskets of stocks that settled in the same market as the underlying securities.
ETFs have broadened from passive baskets to the most active and sophisticated strategies, and are pitched to long-term investors as much as traders. Hedge funds have come to rely on institutional investors – pension funds, endowments and sovereign wealth funds – more than wealthy individuals. Given that at least some hedge fund strategies can help at least some retail investors, the next question is whether the public mutual fund or ETF format is superior. The products are more similar than different, and many funds are offered in both wrappers. The choice involves several factors, but at a high level, ETFs make more sense for long-term holders of relatively passive baskets.
So it seems sensible for retail investors to look at ETF versions of hedge fund strategies they want as permanent portfolio constituents – either core long holdings like risk parity, or diversifiers like managed futures. Aggressive strategies with consistent holdings, like levered ETFs, also make sense for traders, but not for long-term investors.