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Hedge funds pose unappreciated lack of transparency, says ETF proponent


In this week’s column, Algo-Chain’s Allan Lane, a key supporter of ETFs, takes on the interviewee, hedge fund manager, Louis Gargour…

Another day and another headline remind investors of the unappreciated market risks that come with ETFs. This time it is the turn of Louis Gargour, the CIO of LNG Capital, who is raising the alarm of risks associated with High Yield Bond ETFs. If nothing, the level of debate has moved on since the time when Sanford C Bernstein & Co offered their commentary that suggested passive investing was worse than Marxism.


In a week when retail investors were presented with the news that the UK listed small cap stock, Funding Circle, dropped 29 per cent, few if any, need reminding that small cap investments are much riskier than large cap investments. Indeed, for this reason it is worth stating the obvious, diversifying one’s small cap portfolio is the best way to minimise the idiosyncratic risk that comes with this asset class. 


In the same way that I buy into the idea of indexing as an investment strategy, I also buy into the idea that skilled investment managers can outperform their benchmark. I like Louis’ investment thesis: many of the smaller EUR denominated High Yield Bond issues are not eligible for inclusion within the iShares EUR High Yield Corp Bond ETF, providing an opportunity to make alpha. The trouble is how much alpha, and at what risk? And for those of you not paying attention at the back of the classroom, just as with small cap stocks, these smaller issue size bonds are riskier than the larger size issues. How else do you think you are going to get a 12 per cent yield?


As Neil Woodford has reminded us, high returns often come with higher levels of illiquidity. So, I’m not sure how LNG Capital’s Euro High Yield fund will somehow avoid the liquidity crunch when a market correction occurs. In a more extreme case H2O Asset Management has brought the issue of illiquidity into the spotlight, so Louis is right to raise this same issue as applied to ETFs.


Hedge fund investors don’t expect the same level of transparency, that investors in ETFs expect, but if we are talking about under appreciated levels of risk, I would have thought it relevant to mention that a tactical strategy selecting small issue size High Yield Bonds is riskier than a diversified large issue size High Yield Bond index tracker? If not, where is the extra performance going to come from that justifies the higher fees?


To be honest, looking at the level of detail that iShares produces on their web site is almost embarrassing. Did you know that currently the iShares Euro High Yield Corp Bond UCITS ETF, comprises 472 bonds? Or that the ETF has an effective duration of 2.65, and that only 0.21 per cent of the portfolio fails the MSCI ESG – UN Global Compact Compliance Violation selection criteria?


Like it or not, there is no turning back. By all means, highlight some of the unappreciated features of ETFs but do question whether your own fund could even vaguely pass muster under the level of scrutiny that is now commonplace across the ETF industry and is now taken for granted by the next generation of investors. 

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