While exchange-traded funds have traditionally been marketed to retail investors as a cost-effective and easy way to access baskets of stocks, they are becoming increasingly popular with sophisticated European investors such as hedge funds.

The attraction of ETFs lies in the fact that they can be easily traded and can facilitate long or short exposure to underlying assets that may be hard to invest in directly and offer cheaper hedging opportunities. John Lowry, chairman of alternative investment firm ML Capital, said: "There has been a significant uptake in the use of ETFs as an investment tool. We are seeing a growing trend for some managers to utilise ETFs to get 100% of their exposure to underlying markets - there is definitely a growing trend to dedicated ETF-based hedge funds." This is important because hedge fund trading increases liquidity in ETFs, to the benefit of other investors. Claus Hein, head of UK and Nordic ETFs at Lyxor Asset Management, said: "We have definitely seen a significant increase in the number of hedge funds using European-listed ETFs across a variety of investment strategies and to gain exposure to many different market segments such as equity sectors, emerging markets and fixed income. ETFs are viewed as effective implementation vehicles for both long and short positions, and as liquid products that can be traded on-screen and through multiple ETF liquidity providers." In the US, hedge funds have long been active users of ETFs, but uptake of the instrument in Europe is a relatively new phenomenon, partly for historic reasons. In the US, the ETF market was already active when many hedge funds set up at the start of the past decade, so there was a wide choice of ETFs already available. Daniele Tohmé-Adet, head of ETFs and indexed funds development at BNP Paribas Asset Management, said: "Hedge funds fancy the use of ETFs for the sake of being able to go long or short the underlying indices that are not offered in the shape of futures. In Europe, the lending-borrowing ETF market has yet to develop and is not really equipped yet for ETF shorting. Shorting in the US costs an average of 10bps to 15bps while it can be 10 times more expensive in Europe." Hedge funds can use ETFs in various ways. One is by global macro traders, who may bet on the state of a sector, or sub-sector, relative to the broader market. By using ETFs, more time can be spent focusing on sectors rather than creating a basket of securities to represent a sector. ETFs can also be used by long/short equity managers to attempt to generate alpha and eliminate broad market exposure. Hedge funds can go short on an ETF when it is not possible on the underlying asset, for example, with an emerging market index. In this case, ETFs can be used to go short if they are available for borrowing from the ultimate owner. Manooj Mistry, the head of db x-trackers, Europe, said: "In the US, where the ETF market is four times the size of Europe, prime brokers and others can obtain ETFs to go short. In Europe, there is not the same depth of market, but some participants are trying to instigate more borrowing by 'create-to-lend' facilities, for example, as a means of increasing the involvement of hedge funds." Create-to-lend facilities let providers create new units in an ETF specifically for lending. Nicco Ferrarini, head of the broker-dealer sales team at iShares, said the ability of prime brokers in Europe to borrow ETFs for hedge fund clients has improved in the past couple of years. He added: "A problem in Europe is that a lot of owners of ETFs are not aware they can lend them and make a profit from doing so." Another possible use of ETFs is for tail-risk hedging, or protection against extreme market volatility. Antoine Haddad, managing partner of hedge fund of funds Bainbridge Partners, said this can be done by buying volatility via options, by investing in strategies with a similar pay-off to long options but without their time decay, or using a new generation of volatility ETFs. Like swaps, ETFs tracking an index have a delta, or sensitivity, to the underlying index of one. However, compared to swaps, ETFs have a much lower level of counterparty exposure. Ferrarini said: "What we saw after the Lehman Brothers collapse in 2008 was the need for the hedge funds that survived to reduce counterparty exposure. Swaps have a much greater intrinsic counterparty exposure than ETFs and that has been a major factor for hedge funds in Europe to look again at ETFs." Haddad agreed: "You have counterparty risk on swaps, whereas ETFs are cleared on an exchange and are much safer." Another benefit of ETFs over swaps is their operational simplicity. Swaps are efficient products, but are complex from an operational point of view, requiring swap agreements to be in place, collateral to be posted and regular valuations conducted, which puts a burden on middle and back office functions. In comparison, ETFs are very easy to use, but hedge funds need liquidity if they are to use ETFs. Ferrarini said: "In the US, hedge funds can send orders electronically, but for larger orders in Europe, clients will have to call a broker and trade over the counter on the phone. That has put off hedge funds from trading ETFs and there is a lot of focus at iShares on increasing exchange liquidity to attract hedge fund business." Deborah Fuhr, managing director and global head of ETF research and implementation strategy at BlackRock, which acquired iShares when it bought Barclays Global Investors in 2009, said: "ETFs can be traded with multiple brokers, whereas swaps are usually traded with the same broker and hedge funds like to be as opaque as possible. They prefer trading with multiple brokers, so no one broker knows what they are doing." While the uptake of ETFs by hedge funds is growing, Mistry said: "We are at the start of a curve that will increase over time, but hedge funds are currently a very small proportion of total ETF assets and usage. Operationally, people are still working out the most efficient way for hedge funds to borrow ETFs to go short, as there can be questions over dividend payments, depending on the type of ETF being borrowed."