Closer Look At Hedge Fund ETFs

by on July 27, 2010 | ETFs Mentioned:

The past few years have seen no shortage of innovation in the ETF space; targeted international products, state-specific funds, and single-commodity ETPs are just a few of the developments to come out of the rapidly-expanding industry. Some of the most interesting products to hit the market recently are found in the Hedge Funds ETFdb Category, offering exposure to strategies that have historically been off limits to most investors.

Many investors have some misconceptions about the hedge fund asset class; stories of outrageous returns generated in the 1990s and early 2000s have led them to believe that hedge funds seek to generate massive absolute returns by taking on significant risk. But in reality, hedge funds aren’t always out to generate eye-popping absolute returns. As the very name of these vehicles suggests, most hedge funds are designed to hedge, dampening volatility and providing diversification benefits to traditional stock-and-bond portfolios [see Early Leaders In The Active ETF Race].

In an environment where correlations between stocks, bonds, and even commodities has gone through the roof, identifying non-correlated assets is both increasingly challenging and increasingly important. Hedge fund ETFs present an intriguing option for investors looking to reduce the overall volatility of their portfolios, as many funds in this category maintain relatively low correlations to stocks and bonds.

Benefits For Big And Small Alike

Hedge fund ETFs aren’t necessarily only designed for smaller individual investors. Frustration with traditional hedge funds has surged in recent years, thanks to a wave of scandals, poor performances, and fund closures. Hedge fund ETFs offer a number of advantages over traditional hedge funds, including enhanced transparency, significantly lower fees, and superior liquidity [see Will Hedge Fund ETFs Replace Hedge Funds?]. It’s difficult to tell exactly who’s investing in any particular fund, but it wouldn’t be all that surprising if some big institutional investors were among those holdings the funds profiled below; they offer many of the benefits of traditional hedge funds without a lot of the common headaches.

IQ Hedge Multi-Strategy Tracker ETF (QAI)

This ETF is the most popular in the category, and implements perhaps the most broad-based strategy. QAI attempts to replicate the risk-adjusted return characteristics of hedge funds using various investment strategies, including long/short equity, global macro, market neutral, and fixed income arbitrage.

QAI is structured as an “ETF of ETFs,” meaning that its underlying holdings consist of other exchange-traded funds. By combining various asset classes together in certain proportions, QAI is able to produce returns indicative of the hedge fund asset class [see Under The Microscope: QAI].

iShares Diversified Alternatives Trust (ALT)

This member of the iShares product line doesn’t seek to replicate an index, striving instead to maximize absolute returns from investments with historically low correlation to traditional asset classes. ALT seeks to capitalize on relative value strategies, seeking profit by capturing spreads between assets and asset categories that deviate from fair value [see iShares: No Longer Just An Index-Based ETF Provider]. Like most hedge funds, ALT establishes both long and short positions within each asset class, seeking to generate profits from “market neutral” positions. ALT’s general strategies include:

  • Yield and Futures Curve Arbitrage: This strategy seeks to take advantage of interest rate and futures price differentials by entering into both long and short positions in futures on bonds, interest rates, commodities, and currencies.
  • Technical Momentum/Reversal: This strategy is based on the theory that past price history may be predicative of asset value. For example, if recent performance exceeds historical performance, a long “momentum” trade opportunity may arise.
  • Fundamental Relative Value: This strategy seeks to identify discrepancies between market and fundamental values of an asset, thereby profiting from an ultimate reversion between the two.

IQ ARB Merger Arbitrage ETF (MNA)

This ETF offers exposure to a strategy commonly employed by hedge funds: merger arbitrage. The index underlying MNA consists of global companies for which there has been a public announcement of a takeover by an acquirer. Once a transaction is announced, the share price of the target tends to hover below the announced price, reflecting the risk that the transaction will ultimately not be consummated. If the deal closes as planned, this strategy nets the difference between the purchase price and the price paid prior to the closing of the transaction.

There is, of course, risk associated with this strategy; if the deal falls through for any reason, the share price of the target is likely to plummet, immediately erasing most of the premium that the acquirer had been willing to pay. It’s worth noting that MNA also maintains short exposure to global equity markets as a partial equity market hedge [see Will Cash-Rich Companies Boost MNA And PKW?].

IQ Hedge Macro Tracker ETF (MCRO)

This ETF seeks to replicate the risk-adjusted return of hedge funds pursuing a macro strategy. That means utilizing macro analysis (political trends, macroeconomic developments) to identify dislocations in equity, fixed income, currency, and commodity markets. Like QAI, MCRO’s underlying assets aren’t exotic securities available only to the largest and most sophisticated investors; holdings consist almost exclusively of popular ETFs, including EEM, LQD, and SHY. Again, the value added by MCRO comes from the lengthy research done to determine the combination of these asset classes that will produce hedge fund-like returns [also read Inside The Five Most Expensive ETFs].

Credit Suisse Long/Short Liquid Index ETN (CSLS)

This product from Credit Suisse offers investors a way to access a strategy that receives one of the largest allocations in most hedge fund portfolios. This product is linked to an index that utilizes an algorithm to determine appropriate market factors and weightings across various asset classes. The Credit Suisse Long/Short Liquid Index reflects the return of a dynamic basket of liquid, investable market factors selected and weighted in accordance with that algorithm. It’s worth noting that CSLS is an exchange-traded note, meaning that investors are exposed to the credit risk of the issuer.

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Disclosure: No positions at time of writing.