Active Management Vs Passive
Hedge Funds
ETF (Passive)
In the past years, ETFs that provide hedge fund strategies have increased in popularity. These strategies appeal to investors because of their higher liquidity and accessibility. The two most common hedge fund ETF strategies are hedge fund replicators (Hedge fund Beta) and those that track actual performance (Hedge Fund Alpha). In hedge fund beta strategies, ETFs attempt to replicate hedge fund returns by acquiring exposure to certain markets. For example, in the case of convertible bond arbitrage, the passive index would buy all convertible bond issues that conform to certain characteristics such as size and liquidity and short the common stock of each issuer (Kellett).In other words, the index attempts to mimic the hedge fund strategies without trying to pick out the best deals. This type of ETF does not track hedge fund performance but attempts to replicate it. Additionally, hedge fund beta strategies can be a lower cost alternative because they are cheaper to run and provide transparency by investing in liquid securities
In hedge fund alpha strategies, ETFs attempt to track actual hedge fund performance through direct investments in the hedge funds themselves. In contrast to beta strategies, alpha strategies do not provide full transparency of the fund composition in a given period. These ETFs have high expense ratios in addition to the hedge fund fees which are embedded in the indices (Lauricella).
Mutual Funds (Active)
For many years, mutual funds have provided long only investment strategies. Recently however, mutual funds are offering strategies that profit when stocks or bonds fall. According to Barrons magazine, 300 mutual funds now offer exposure to alternative strategies such as long/short equity, market neutral, and managed futures. For example, in a long/short equity strategy a mutual fund will buy undervalued securities and short overvalued securities. Similar to hedge fund ETFs, mutual funds offer the benefits of improved liquidity and transparency. However, mutual funds with exposure to alternative strategies do not have a long track record of performance (Uhlfelder). Additionally, mutual funds are required to set daily prices and adjust to asset base fluctuations due to daily liquidity requirements. This is challenging for hedge funds since they use complex trading strategies and deal with less liquid instruments. As a result, these funds tend to invest in more traditional asset classes than can have less upside potential in order to provide the daily liquidity.
Private Partnerships (Active)
Private partnerships are the traditional investment vehicle for hedge fund strategies. The funds are costly in nature. A typical hedge fund charges a 2% annual management fee and an incentive fee of 20% of the funds profits. An investor