Thursday, August 4, 2011

Investing in Hedge Funds with ETFs - Investing Daily

According to the limited publicly available information on hedge fund performance, 2011 has been a less-than-stellar year for the industry. The Barclay Hedge Fund Index--which is maintained by a private company not affiliated with Barclays Bank--shows that hedge funds have returned just 2.3 percent this year and have significantly underperformed the broad market over the past three years.

Macro-strategy funds, in particular, have struggled amid a steady stream of political and economic crises that have erupted even in relatively stable parts of the world. This unpredictable turmoil has prompted a number of hedge fund managers, including the great George Soros, to exit the business.
Hedge funds that employ a quantitative investment strategy have also lagged. Many investors assume that these funds’ “black box” strategies would succeed in any market. But these strategies work best when the market exhibits well-defined trends, of which there has been precious little during the past several months.

Despite a middling performance, hedge funds have experienced strong asset inflows in 2011. With the exception of a scant outflow in July, hedge funds have taken in about $75 billion this year. The mystique of investing in a hedge fund may partially explain this ostensible contradiction. Some investors will always be drawn to the prestige of being an elite, “qualified investor.”
The real reason is probably more mundane: Hedge funds offer investors the benefit of portfolio diversification. Although fund-specific data is in short supply, industry watchers estimate that hedge funds exhibit a 0.7 percent correlation to the broader indexes.

This implies that a hedge fund will perform similarly to its benchmark 70 percent of the time. This correlation may be too close for comfort for some investors, but it does offer a measure of downside protection.
Nevertheless, many investors are eager to put their money to work in a hedge fund. In the past few years, the industry has sought to democratize hedge fund investing with the use of mutual funds and exchange-traded funds (ETF). Given the complexity of the strategies employed by many hedge funds and the rules that regulate trading within mutual funds and ETFs, this emerging trend has benefits and drawbacks.
Exchange-traded funds require high levels of transparency--an investor can see an ETF’s holdings at any time. This precludes the full implementation of hedge fund-like strategies because other market participants can engage in front running. Strangely enough, this drawback may actually benefit investors. Because these funds cannot run esoteric strategies, they must stick with tried and true strategies that dampen volatility and reduce their correlation to other asset classes. Meanwhile, a hedge-fund focused ETF is more transparent and liquid than a typical hedge fund. It’s also far cheaper; hedge-fund focused ETFs don’t charge the usual “2 and 20” fee--2 percent of assets under management and 20 percent of profits--that is common in the hedge fund industry.
I don’t recommend investors include hedge fund-like exchange-traded products in their portfolio. Even in the form of an ETF, these are complicated investment vehicles. But for those investors willing to take the risk, these two offering from Index IQ are a good place to start.

IQ Merger Arbitrage ETF (NYSE: MNA) runs a merger arbitrage strategy; the fund takes long positions in announced takeover targets and occasionally also takes short positions in the acquirer. Additionally, the fund uses short positions in stock index futures and currencies to hedge its broad market exposure. The fund’s portfolio is rebalanced on a monthly basis. I’ve recommended this ETF in the past because its strategy is sensible and easy to understand. Corporations have built up enormous cash hoards that they’re leery of deploying in a weak economy. Nevertheless, these enterprises remain under pressure to create value for shareholders. One of the easiest ways to achieve this goal is to acquire another company.
Global mergers and acquisitions (M&A) volume rose by about 23 percent last year to $2.4 trillion. This year M&A volume is expected to grow by another 35 percent to more than $3 trillion. A rising number of deals means significant opportunity for investors. This is not to suggest that soaring profits are a foregone conclusion for this ETF; M&A deals fall apart regularly. But the fund’s strategy generates an extremely low correlation to the S&P 500 with a low expense ratio of 0.75 percent.