Andy Hagans sits down for an interview with Highland Capital’s Ethan Powell.
ETF Reference editor in chief Andy Hagans recently interviewed Ethan Powell, the chief product strategist at Highland Capital Management. Mr. Powell previously worked for Ernst & Young in mergers and acquisitions. The interview was completed over email in June of this year.
Andy Hagans: It has been a rocky decade for hedge funds. On the one hand, in the financial crisis of 2008-2009, a few hedge funds performed phenomenally, with short positions in MBSs, or long positions in precious metals. However, the majority of hedge funds “laid an egg” in the crisis, leading many investors to question their value relative to their high costs. More recently, a lot of funds (especially smaller ones) are shutting down. Is this a sign that something is wrong with the hedge fund model? Or does this simply reflect an industry that’s consolidating and pruning less competitive, less efficient players?
Ethan Powell: HFR, the leader in hedge fund research and indices, reports that hedge fund investments are at record highs. In fact, they have approximately $3 trillion in AUM today, which refutes the idea that the industry is consolidating. During the downturn, there probably were players in the space that shouldn’t have been there. What you see today is successful hedge funds emerging stronger than ever. 2008 served to separate the weak from the strong. Highland is a $21 billion asset manager, and much of what we manage is in institutional mandates, including hedge funds and alternative strategies in other vehicles, including mutual funds. We’ve been managing alternative strategies for over 22 years. We have the right people, process, and philosophy — a model for success over the long term.
Andy Hagans: The growth of the ETF universe has brought increasing investor access to alternative investments. Many of these alternatives previously required high minimum investments and were mainly bought by institutional or VNHW investors. Will increased retail investor access bring higher prices (and lower future returns) in alternative asset classes? Could these trades become too crowded?
Ethan Powell: Any time you’re looking at alternatives, what really matters is what you are attempting to accomplish with the investment. There are several ways to access alternative investments that deliver noncorrelated investments that have a tremendous amount of scale. The noncorrelated nature of these investment strategies attempts to increase the risk-adjusted return of your portfolio over the full market cycle. Some examples of strategies that can do this with scale include long-short equity and global tactical strategies. These strategies invest in securities that have sufficient liquidity to support continued adoption by the larger investor bases while still generating superior risk-adjusted returns.
Andy Hagans: Asset prices appear rich across the board — equities, bonds, farmland, gold. It seems like nearly everything is trading above its historical long-term average. How do high valuations of core asset classes affect the relative attractiveness of hedge funds and of classic hedging strategies?
Ethan Powell: The current unprecedented low-interest-rate environment has helped to drive prices of all asset classes up. This type of environment is perfect for hedge fund strategies where you’d expect to see sideways trending markets with high volatility. The flexibility of these alternative mandates to short securities gives the investor the ability to win from rising valuations and potentially from lower valuations.
Andy Hagans: Highland’s three new hedge fund beta ETFs (HHFR, DRVN, and HHDG) are interesting in that they don’t actually invest in hedge funds but instead replicate aggregate hedge fund positions. And each of these ETFs has an expense ratio of 85 basis points, which is much lower than a typical hedge fund fee. Obviously, in this space, there’s a strong appeal of active management, but on the other hand, it seems like active managers who charge the typical “two and twenty” will now have to generate enormous alpha merely to break even with competing passive replication products on a net basis. So obviously, some assets will flow from active alternative funds to their passive counterparts. The question is, how much? And how quickly?
Ethan Powell: That will dictate active managers’ ability to deliver alpha in a very uncertain environment. Many managers in the liquid alternative space haven’t had a liquid vehicle during a significant market downturn. Their ability to protect on the downside will dictate how much money stays inactive instead of moving to passive. Highland has two of the longest-running long-short actively managed mutual funds (HEOZX, HHCZX), both of which performed very well during 2008. Our hedge fund beta ETFs represent a good beta complement for those investors who prefer passively managed ETFs to other actively managed solutions.
Andy Hagans: Highland also manages some mutual funds in the alternatives space. Obviously, both “wrappers” — the mutual fund wrapper and the ETF wrapper — have individual strengths and weaknesses. In the long run, which product type is likely to amass more total AUM in the alternative asset classes?
Ethan Powell: Each investment vehicle has pros and cons. We leave it up to the investor to determine which is most suitable for their investment objectives. We are a firm believer that there is room for many competing investment wrappers and that LPs and other unregistered products have a place in investors’ portfolios. Whether it’s a REIT, ETF, closed-end fund, or another investment vehicle, each one of our funds has a place in investors’ portfolios depending on their investment objective.