How Can Hedge Funds Compete With ETFs for Allocations from Private Bank Wealth Management Programs Given the Growing Popularity of ETFs in Such Programs?

Up to and even through the credit crisis, private bank clients (chiefly high net worth individuals and family offices) have provided a notable proportion of the assets invested in hedge funds.  However, like other investors in hedge funds during the crisis, private bank clients were dismayed by hedge funds’ illiquidity, lack of transparency and relatively high fees.  At the same time, a new crop of exchange traded funds (ETFs) has arisen purporting to replicate various hedge fund strategies while offering more liquidity, greater transparency and lower fees.  See “Hedge Fund Replication is Gaining in Popularity, but is it a Viable Alternative to Hedge Fund Investing?,” Hedge Fund Law Report, Vol. 2, No. 28 (Jul. 16, 2009).  More traditional ETFs – those that track broad stock and bond indices rather than seeking to replicate hedge fund strategies – also offer the advantages of liquidity, transparency and lower fees.  Not surprisingly, therefore, a number of private bankers recently have redeemed their clients’ hedge fund investments and reallocated the proceeds to ETFs, both of the replication and traditional variety. Indeed, there is some concern in the hedge fund industry that private banks will turn away from hedge funds altogether, primarily in favor of ETFs.  The purpose of this article is to analyze whether that concern is warranted and, to the extent it is, to explore what hedge fund managers can do to counter the trend.  In brief, this article concludes that for a narrow group of strategies, ETFs may well be able to address the goals of private bank clients as well, on average, as hedge funds.  However, for a wide range of hedge fund strategies – especially those that rely more on the decision-making capacity of one or a few portfolio managers as opposed to replicable quantitative models – hedge funds are likely to retain an important role in serving the uncorrelated return and diversification goals of private bank clients.  In particular, this article discusses: what private bank wealth management programs are; the three mechanisms by which private bank clients invest in hedge funds; what ETFs are; how certain new ETFs seek to replicate hedge fund strategies; the growing popularity of ETFs for private bank clients; the benefits and drawbacks of ETFs for private bank clients; the three primary ways in which hedge funds can remain relevant in private bank portfolios in light of the growing popularity of ETFs; and the utility and limits of side letters for private banks.

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