IU: Where does the line blur for you between alpha and beta? Because with ETFs, it seems like that line may be becoming more blurry.

Kang: I see a horizontal line, which I call the active-passive spectrum. At the extreme left, let's just call that beta, let's call that market risk, let's call that extremely cheap exposure to an investment, let's call it an ETF or a derivative. At the very other end, on the right side, let's call that alpha, let's call that absolute return, let's call that hedge funds, let's call that high fees, let's call that managed risk. So on the left is market risk, and on the right is manager risk.

Everyone has been talking in the past three or four or five years about the separation of alpha and beta, and you can see that on the left side in the growth of the ETF industry, and at the same time, on the right side in the growth of the hedge fund industry. Even though the mutual fund business is still very large, they're kind of losing their reason for being and their value, because people are saying I can build better portfolios with ETFs and hedge funds through this whole alpha-beta separation philosophy.

What interests me is that I think what's happening is actually alpha and beta convergence. If you look at the far left side, what's happening to the ETF space? They're not building any more SPYs at less than 10 basis points; they're now building niche-sector and thematic ETFs and exotic regional ETFs, with higher fees and less diversification. We're not talking 500 underlying stocks, we're talking about indices with maybe 60 underlying securities, and you're pushing inwards to the right-they're not just at the polar left anymore. ETFs are wanting to push in more toward the center and wanting to have higher fees. They're wanting to have higher margins and wanting to explore in the fringes of the capital markets.

At the other end on the right side, hedge funds in aggregate actually have a lot of beta in there. They don't like to advertise that because then they look like they're almost closet indexing like a mutual fund, but that's the reality. The hedge fund indices track very closely to equity indices. Hedge fund indices themselves are another example of the tendency to push inward. You're indexing something that's not supposed to be indexed.

And then you have hedge fund replication, which is basically legitimizing the fact that there is beta in hedge fund strategies and people are saying I can put together some combination of factors (alternative betas) and come pretty close to a hedge fund type of strategy-again, pushing inwards from the right side.

Wall Street is now attempting to plug in all the holes in between these two poles on that spectrum. That's what's happening right now.

So is it blurring the alpha-beta world? Yes, it is, but at least it's not outright insincerity. Maybe that's too harsh a word in terms of mutual funds, where they are saying, "We outperform the market and we do well. We pick good stocks, and we avoid bad stocks." They say stuff like that, but the reality is that they're not able to do it-not because they are deceptive but because the laws don't allow them to be fully diversified. Their constraints don't allow them to have more than a fixed percentage in a particular position. They don't allow them to short. There's a long list of restrictions imposed on mutual funds so at the end of the day there's no benefit for them to go too far beyond the index, and that's what closet indexing is. It's bad with mutual funds, but the fact that you see it in aggregated hedge funds-hedge fund indices and many fund of funds-is troubling.

IU: Are there any assets classes or areas that you think could use some more coverage by ETFs?

Kang: I think emerging markets have a long ways to go, and I think we're not as developed there in the ETF space because of the logistical constraints. ETFs require a certain amount of liquidity. ETFs are meant to be low-cost instruments, but once you get into emerging markets, costs are quite a bit different. In some cases, just the infrastructure in an emerging market doesn't allow for very fluid movement of capital, and it just makes it difficult.

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