Exchange Traded Funds

Using the right cash tools

Originally published in the July 2007 issue

Hedge fund managers, like most other types of investors, appreciate streamlined tools and solutions that make it easier for them to deliver performance. In this space, both exchange traded funds (ETFs) and money market funds (cash funds) are winning loyal followings because they deliver efficiencies across a range of strategies and market exposures.

Utilising both sets of products more fully can free up a manager to focus on their core role of determining and capturing investment opportunities, as they can reduce the time and resources required to execute some of the possibly non-core investment duties that hedge fund managers must often undertake. A key area for consideration is designing and executing an optimal strategy for managing cash.

ETF boom

ETFs burst onto the scene back in the early 1990s, and the assets invested in them and the number of funds available have grown at an impressive rate – see Figure 1. Estimates now suggest that the assets invested globally in ETFs will reach US$2 trillion by 2010.

For the less well acquainted, ETFs are listed funds trading on stock exchanges across the globe. As flexible as any stock, these funds can be bought and sold during normal trading hours and settle in the standard way for equities. Similar to an index tracking pooled fund, an ETF seeks to reflect the performance of a chosen index. This is achieved through holding a diversified underlying basket of assets.

The range of indices and markets that ETFs provide access to has continued to expand at a rapid pace. Funds tracking broad-based indices like the S&P 500 and FTSE 100 have been joined by ETFs offering exposure to specific market segments, investment styles and global industries, regions including emerging markets as well as various fixed income markets and alternative asset classes, such as property, infrastructure, commodities and listed private equity.

Equitising cash

An unintentionally large cash balance, whether during a shift in asset allocation or while selecting securities, can dilute the performance of an otherwise successful hedge fund strategy. So, for many managers, investing (equitising) cash rapidly and cost effectively to gain an exposure to a desired market, sector or asset class, is a priority.

Until recently, most investors relied upon futures contracts or swaps to accomplish this goal. However, with the proliferation of ETFs, investors have a new route to efficiently equitising their cash. As we look at the hedge fund market, there are a number of scenarios where ETFs can be considered as an alternative to synthetics in this area. Both of the following scenarios are effectively equitising cash, but for different reasons and with different outcomes.

Imperfect timing

Hedge fund managers can find themselves with cash in their portfolio but limited opportunity to put it to work. This can be driven by the liquidity of their targeted securities, timing to generate ideas as research is completed, or for the lucky few, by being victims of their own success as investors pour money into the fund faster than it can be invested. Under all these circumstances, the portfolio manager must decide what to do, temporarily, with the excess cash. Certainly, leaving it in cash on deposit is an alternative and one that was frequently used in the past. However, most managers recognise that this may be a sub-optimal solution. The better solution is often to equitise that cash with a vehicle which provides exposure to the desired market or asset class.

The increase in exchange traded products has afforded managers many new choices, including almost all the major equity and fixed income index providers’ benchmarks, as well as areas like private equity, global sectors, commodities and property.

The proliferation of new ETFs is particularly valuable in those market segments that have been challenging to access in the past. A good example of a potentially ‘hard to get’ market segment and one in which specialist hedge funds are active is listed private equity. As unquoted companies, gaining access to these vehicles is innately more difficult and time consuming than buying into a listed stock. As a result, even when the background research has been concluded and an investment decision made, there may still be a significant lag between the moment when a hedge fund wants to buy into a listed private equity vehicle and when they are actually able to make an investment.

The very recent advent of an ETF designed to reflect the performance of the S&P Listed Private Equity Index provides investors with liquid and diversified exposure to the listed private equity space, via a single trade. This index consists of around 25 of the most liquid stocks of leading publicly listed private equity companies operating from North America, Europe and Asia. So while the investment decision is being assessed, or if access to the private equity company is not immediately forthcoming, a private equity-focused hedgefund manager need not be sidelined in cash, as a liquid route to gaining a representative market exposure is now available.

Shifting allocations

For many managers, maintaining a specific overall asset allocation is an important component of a strategy. As asset class returns vary, the portfolio’s overall allocation deviates from the target.

Historically, investors have managed this process by moving money from the overweight asset class and investing in the underweight asset class. While this accomplished the goal, it often came with significant trading costs.

Historically, investors have managed this process by moving money from the overweight asset class and investing in the underweight asset class. While this accomplished the goal, it often came with significant trading costs.

ETFs have changed the landscape and fund managers are beginning to see that holding a portion of their total portfolio in a basket of ETFs could afford them the opportunity to more efficiently manage their asset allocation.

Money market solutions

Hedge funds are also looking at the potential advantages of using money market funds. Incorporating these products represents the next step in an effective cash management strategy, working in concert with the benefits delivered in terms of cash equitisation via ETFs.

Money market funds offer flexibility and ease of use, providing access to a liquid pool of high credit quality assets that deliver an alternative means of gaining access to wholesale money market and enhanced cash rates. Typically, money market funds have been designed to offer capital preservation and instant access to cash, while achieving a competitive yield. New strategies are emerging against a constant background of innovation and funds generating enhanced cash yields represent a valuable tool for hedge fund managers.

For most hedge funds, there are two key roles that money market funds usually fulfil. The first is looking after the manager’s cash used as working capital. The second role is utilising the cash that’s generated by the hedge fund itself.

On the balance sheet

Cash that forms part of the working capital for a hedge fund can be invested into AAA rated, or potentially lower-rated money market funds. This allocation is usually made to one or several strategies, and this decision will be a function of the treasury policy or liquidity requirements of the investment management company.

Managing this surplus cash across liquidity strategies or just ‘potted’ in to one particular vehicle can provide excellent liquidity, as well as an enhanced cash yield. Using money market funds in this way also highlights their ease of access and simple administration and an alternative solution to bank or direct money market deposits.

Within the fund

A second pool of liquidity is generated by the hedge fund itself, which can be sub-divided into three underlying categories and ultimately allocations. If managed effectively using money market funds, these balances also offer the potential to deliver enhanced returns for the overall hedge fund strategy itself.

First, liquidity that is generated by clients’ subscriptions and redemptions. This cash may sit within low interest bearing accounts, until the hedge fund manager decides to fully invest the cash or pay back to clients. Typically, this pool of capital can be invested in a money market fund that offers a high degree of liquidity, capital preservation and high credit quality.

Secondly, the cash used within the collateral and margin management. On a frequent, sometimes daily basis, a hedge fund needs to pledge or pay cash to its prime broker. Based upon the mark-to-market profits or losses on its futures positions, for example, the fund can hold that cash in a money market fund until required. Depending upon the cash forecasts, or expected gains and losses, cash can be allocated across a range of money market funds and blended to give a more optimised return rate.

Thirdly, unencumbered cash, defined as money that is not invested in futures or physical securities, can sometimes be the most substantial pool of cash in a hedge fund. It may also be a relatively stable position over the longer term. This balance of more stable cash can be invested into products that target cash-plus type returns. Where a hedge fund manager may be managing large pools of cash, efficient liquidity management can make a significant contribute in achieving hurdle rates across the portfolios.

Ultimately what occurs is a ‘laddered’ liquidity profile, as shown in Figure 2. Viewing a fund’s cash requirements in this way and implementing a flexible cash solution is increasingly being looked at by hedge fund managers as a way in which they can to optimise their cash exposure.

Optimal cash strategy

Overall, hedge fund managers are making use of a wider range of tools to enhance the returns that they can generate from their various cash balances, as well as enhancing their ability to equitise cash and execute their views.

Innovation, flexibility and simplicity are all factors that may prove influential in determining the selection of both ETFs and money market funds in the pursuit of a comprehensive cash management strategy. Hedge fund managers may also be rewarded by seeking out product providers that are able to offer innovative and comprehensive ranges of both types of solutions.