A reader wrote a no doubt heartfelt, but misguided comment, which I thought bears dissection:

The other day, I went looking through my favorite market stats to see if any remaining profits could be pounced upon. Typically, profit possibilities can be identified quickly on NYSE lists of the largest dollar and percent gainers.

Alarmingly, 75% of the largest percent gainers were ETFs, and many of those operate using the same strategies as classic hedge funds— most owned no common stock at all!

The classic hedge fund (note the singular, for there is only one classic hedge fund, The Jones Organization) was an equity market-neutral shop, so it did in fact own stocks. As to the ETFs, they by and large do not run hedge fund-type strategies; most are index-based, a few are actively managed, a small but growing niche is enhanced indexing.

As to ETFs owning no common stock at all, they do exist (examples include fixed-income, currency, and commodity ETFs), but why is it such a bad thing? A good investment strategy does have room for these asset classes, and ETFs provide a way to get those exposures both cost-effectively and tax-efficiently.

What is a hedge fund, and just what does it try to accomplish?

These days, a hedge fund is mostly a form of business organization. Domestic hedge funds are structured as limited partnerships, and there are also offshore hedge funds structured as various limited liability entities in convenient jurisdictions. The term no longer implies any particular investment strategy.

I think the key legal element is that they don’t say how they intend to get the job done.

Clearly, you’ve never bothered to check out a hedge fund database… CS/Tremont, Hennessey, TASS, and MAR/Hedge all have strategy classifications on hedge funds, most of which specialize in one or few strategies (e.g., equity long-short, global macro, fixed-income arbitrage, emerging markets, etc.)

Also, performance history of a fund can talk louder than its managers. Check out Andrew Lo’s 2001 FAJ paper for some easy-to-implement ideas based on linear regression. If you understand factor analysis, you can do even more sophisticated things…

Initially, hedging was used as a risk mollifier in the securities markets in the same way as insurance is used for protection against disasters impacting life, health, and personal property. Taking a short position on an owned security, for example, protects an investor’s profit if the company’s market price plunges.

???

The Jones Organization (the original hedge fund) never took a short position in a security it owned. Instead, it made sure to always be short securities it didn’t own. Essentially, it allowed it to capture the outperformance (rather than raw performance) of stocks it did own.

The new definition of hedge fund speaks of an aggressively managed entity that uses leverage, long, short, options, futures, and derivative positions with the goal of generating high returns. Risk reduction is no longer the objective.

And why should it be? Risk reduction is a portfolio-level concept. The best thing hedge fund managers can do for their clients is to provide high absolute returns whose correlation to stock and bond markets is low. Reducing risk is the responsibility of the overall portfolio manager, who should appropriately size the portfolio’s allocation to hedge funds in general and specific funds and strategies in particular.

A few years ago, the masters of the universe rediscovered, redefined, and complicated the world of closed end mutual funds by creating many different forms of passively managed index/hedge funds.

So is it index or hedge? Also, recall that stock index futures (and options on them) have been traded for decades before the first index ETF hit the market…

As innocent as these funds may appear, they too have altered the investment landscape. Speculators (not investors) place their bets on the rise or fall of the index.

Well, it just so happens that there is a good case for speculation as opposed to investment.

Pick a stock, any stock, or even an index. Pick a period, any period, as long as it’s reasonably lengthy (two years should be long enough for this experiment). Compute the annualized volatility of the stock based on weekly data. Then repeat the computation (same security, same period) on daily data. You will discover that the latter volatility is consistently higher than the former. (Intraday volatility, incidentally, will tend to be even higher.) What this means that there are, theoretically at least, profit opportunities for high-frequency trading.

Or consider the evidence on partial predictability of stock market returns. The Bostian model, Yardeni’s “Fed model”, and Tobin’s q all tend to pinpoint the periods during which the stock market is overvalued or undervalued. Implementing these strategies with ETFs is cost-effective even for an individual investor…

These bets artificially impact the market price of securities because many (if not all) of the funds actually own the securities they are tracking.

They do, but you need a magnifying glass to see the impact. Read some research on performance of the stocks added to (dropped from) major indexes around the time of adding (dropping).

Aren’t these funds artificially taking common stock pricing further and further away from the fundamentals of the companies themselves?

Perhaps, but so do the traditional mutual funds. Also, recall that there are short ETFs, which short stocks rather than buy them.

Apparently, the SEC has not taken the trouble to look inside the thousands of boutique ETFs that by now must outnumber the securities they are tracking.

That is actually quite normal. Traditional mutual funds have outnumbered stocks for a while; why should ETFs be different?

And the real crime is this: investors as naive as the wet-diapered E-Trade spokesbaby can push a button and buy operational hedge funds more bizarre and sophisticated than any ever imagined buy the rich and famous.

How is that different from buying Pets.com, Enron, or Tyco? The danger is real, but it is not by any means new; this is something that investors have had to contend with for a long time.

Should your mother’s IRA be speculating in puts on Netherlands Tulip Bulb futures? How about 200% of the inverse of the Financial Select Sector Index?

If your mother’s IRA has a model that allows it to earn high risk-adjusted returns by consistently timing the market, why not?

Whatever happened to stocks and bonds?

Nothing; and that’s the point. Rational investing has always been about asset allocation. ETFs offer a way to do asset allocation at low cost and more tax-efficiently compared to traditional mutual funds, not to mention buying stocks and bonds directly.