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Thursday, June 26, 2008

Hedgers and ETFs: An Explosive Mix?

News summary by MFWire's editors

Through the end of April, exchange-traded funds raked in more net flows ($26.1 billion) than either index mutual funds ($23.4 billion) or actively managed mutual funds ($24.9 billion), according to the Simfund data published by New York-based Strategic Insight. No wonder the broad financial media is focused so finely on ETFs.

That is also good news for ETF sponsors. One ETF -- ProShares UltraShort Oil & Gas ETF -- has grown its AUM nearly 10 fold this year -- even excluding market gains. It started the year with fewer than $270 million of assets and has net flows of $2.5 billion so far.

Yet, fund marketers casting a jealous eye on the asset gathering prowess of the ETF set may want to take note that the typical ETF shareholder looks nothing like the typical buyer of active funds, or even index mutual funds for that matter.

Roughly half of all ETF flows originate with hedge funds, say fund industry executives.

The Thursday WSJ Fund Track indirectly picks up on this all-important trend by focusing on how hedge funds are betting on leveraged funds offered by ETF sponsors such as ProFunds and Rydex.

Reporters Gregory Zuckerman and Mara Lemos Stein -- both new names to the Fund Track -- write that hedge funds using these leveraged ETFs may be riskier than they appear. Among the hedgers reportedly using leveraged ETFs are: PilotRock Investment Partners, Harbinger Capital Partners, SAC Capital, Gallatin Asset Management, Galleon Group, Jabre Capital Partners and Millennium Partners.

Fund sales people who dealt with market timers during the pre-Spitzer era may, of course, remember the Millennium name. That hedge fund agreed to re-pay $124 million in "ill-gotten" fund trading gains as part of a settlement with the New York Attorney General.

So why are the hedgers using ETFs for their leverage boost rather than their traditional means? The reporters suggest that banks are tightening the lending to hedgers, causing them to seek other ways to lever their gains (and losses).

"More funds are using these ETFs lately because they provide smaller and midsize funds an effective and efficient way to get leverage," the article quotes ProFunds chief Michael Sapir as saying.

Another possibility raised in the piece is that hedgers are using the funds to get around leverage limits as the ETFs are reported as straight equity without leverage.

Yet, a third reason is the tight market for borrowing shares to go short makes the ETFs a cheaper route to making a negative bet on the direction of the market.

Finally, some long-only hedgers may be making a hidden negative bet on the market by using an ETF that bets on a market fall.

All of these reasons are possible, but the article does not get any evidence straight from the horses ... er, hedgers ... mouth. 

Edited by: Sean Hanna, Editor in Chief

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