It’s no secret that more and more hedge funds are aggressively using exchange traded funds, and not just to hedge. Many of them are using these index-like investments to make single-sector — or single-market — bets. For example, at the end of the first quarter, Traxis Partners, headed up by former Morgan Stanley strategist Barton Biggs, held a dozen ETFs, and six of them were his largest holdings, including funds that specialize in health care and Brazil.
But as more and more hedge funds use ETFs to make bets on the broad market or on a specific sector, they risk tripping a modest ownership threshold.
In a recent memo to clients, the law firm Pillsbury Winthrop Shaw Pittman noted that under the Investment Company Act, private investment funds such as hedge funds are prohibited from acquiring more than 3 percent of ETFs. In addition, they are not permitted to invest more than 5 percent of their assets in a single registered investment company or more than 10 percent in registered investment companies. Pillsbury, however, stresses that only the 3 percent limit applies to hedge funds, because they are not considered investment companies.
Hedge funds that do exceed the 3 percent threshold, however, could be forced to liquidate their positions or their managers could be subject to penalties, according to George Mazin, a partner of law firm Dechert.
In order to exceed that level, hedge funds must seek exemptive relief from the SEC — and that’s not easy to get. “This usually requires satisfying a substantial number of conditions, which are similar to those that would apply to an investment company seeking relief to invest in unaffiliated mutual funds, including a number of conditions designed to limit the influence that an acquiring fund may exercise over a particular ETF,” Pillsbury explains in its report.
Still, the 3 percent threshold does not appear very difficult to exceed, especially given that many ETFs are pretty small.
In fact, one hedge fund firm that seems to be clearly in violation of this rule is Paulson & Co. At the end of the first quarter, it owned about 9 percent of SPDR Gold Trust PSE, easily making it the ETF’s largest investor. The Trust holds gold bars and seeks to reflect the performance of the price of gold bullion. The shares trade on NYSE Arca, under the symbol GLD.
However, upon further inspection, Paulson has not broken any rules. This is because the Trust only invests in gold bullion, and not in shares of gold producers, or futures contracts on the price of gold.
It is not a security.
In fact, the Trust states in regulatory filings it is not registered as an investment company under the Investment Company Act of 1940 and is not a commodity pool for purposes of the Commodity Exchange Act of 1936, and not subject to regulation by the Commodity Futures Trading Commission as a commodity pool operator or as a commodity trading advisor.
The upshot: Paulson’s position in Gold Trust ETF is perfectly legal. However, other hedge funds better be careful with ETFs that are subject to SEC and CFTC rules.
