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In the broadest sense, the usefulness of hedge funds comes from their supposed ability to generate returns that are uncorrelated with the market. During the broad asset price appreciation, many hedge funds have underperformed the S&P 500. This is not bad if you understand investing, diversification, and the role of hedge funds in a portfolio. It is bad if you don't understand these things and can only read a historical return.

As retail investors, we have been able to taste some of hedge fund strategies through many relatively new long/short ETFs (exchange-trade funds) and ETNs (exchange-traded notes). Are they performing similarly to the hedge fund industry?

Risk On, Game Over? Hedge Funds Closing

The recent failure and consequent closure of many hedge funds due to unprecedented market conditions is bound to continue if the current financial situation does not improve. Funds are not generating the expected high returns in the struggling economy, and those that are not covering their operational costs are closing down. Because hedge funds are supposed to produce high returns even in weak markets, many investors are dissatisfied and are pulling out. Investors would get much better returns by investing in funds that track S&P 500.

Managers are unhappy, too, as they hardly see lucrative performance fees anymore. Managing hedge funds is arduous work. Europanel Research and Alternative Asset Management Chief Investment Officer Olivier Kintgen indicated that shrinking asset bases have also pressured hedge funds to close down. According to Kintgen:

If you are down 7 percent over two years without a strong financial backing it will be hard to hire and to make returns

Edoma Partners is one major hedge fund that has closed down, and many more are following suit. Some investors, however, are of the view that quite a number will hold their ground and struggle to survive since there are not too many opportunities elsewhere.

Considering Long/Short ETFs and ETNs

Here is a short list of long/short ETFs and ETNs:

Fund Name

Ticker

Inception Date

Expense Ratio

iPath CBOE S&P 500 BuyWrite Index ETN

BWV

22-May-07

0.75%

PowerShares S&P 500 BuyWrite

PBP

20-Dec-07

0.75%

ProShares Credit Suisse 130/30

CSM

13-Jul-09

0.95%

Credit Suisse Long/Short Liquid Idx ETN

CSLS

22-Feb-10

0.45%

Accuvest Global Long Short ETF

AGLS

8-Jul-10

1.50%

Credit Suisse 2X Merger Arbi Lqd Idx ETN

CSMB

7-Mar-11

0.55%

UBS E-TRACS Fisher-Gartman Risk Off ETN

OFF

29-Nov-11

1.15%

UBS E-TRACS Fisher-Gartman Risk On ETN

ONN

29-Nov-11

0.85%

AlphaClone Alternative Alpha ETF

ALFA

31-May-12

0.95%

AdvisorShares QAM Equity Hedge ETF

QEH

7-Aug-12

1.64%

Of these, performance the year from the end of November 2011 to the end of November 2012 was analyzed. ALFA(NYSEARCA:ALFA) and QEH (NYSEARCA:QEH) were omitted because they have not yet been in existence for 12 months. Using total return, here is the value of $100 invested for this period:

(click to enlarge)Long/Short Fund Performance

With the exception of ProShares Credit Suisse 130/30, ticker (NYSEARCA:CSM), really none of these funds kept up with the S&P 500 ETF (NYSEARCA:SPY). The UBS E-TRACS Fisher-Gartman Risk On ETN (NYSEARCA:ONN) outperformed the UBS E-TRACS Fisher-Gartman Risk Off ETN (NYSEARCA:OFF), but neither came close to the S&P 500.

I expect that fund managers are not thrilled with these results, since investors tend to chase returns. Since we wish to take the high road, we can try to find if any of these funds provide alpha and which provide substantial diversification:

Fund Name

Ticker

Inception Date

Expense Ratio

Correlation

Alpha

iPath CBOE S&P 500 BuyWrite Index ETN

BWV

22-May-07

0.75%

0.4296

0.0001

PowerShares S&P 500 BuyWrite

PBP

20-Dec-07

0.75%

0.8522

0.0000

ProShares Credit Suisse 130/30

CSM

13-Jul-09

0.95%

0.9478

0.0000

Credit Suisse Long/Short Liquid Idx ETN

CSLS

22-Feb-10

0.45%

0.4090

-0.0002

Accuvest Global Long Short ETF

AGLS

8-Jul-10

1.50%

0.2208

0.0000

Credit Suisse 2X Merger Arbi Lqd Idx ETN

CSMB

7-Mar-11

0.55%

0.2422

-0.0006

UBS E-TRACS Fisher-Gartman Risk Off ETN

OFF

29-Nov-11

1.15%

-0.8180

0.0002

UBS E-TRACS Fisher-Gartman Risk On ETN

ONN

29-Nov-11

0.85%

0.7557

-0.0004

Is there fabulous alpha to be found here? No. However, there is diversification at low cost. With expense ratios near 0.5%, CSMB (NYSEARCA:CSMB) and CSLS (NYSEARCA:CSLS) are attractive ETNs which have low correlations with the market. Investors seeking to take the edge off market volatility should consider these two ETNs as components of their portfolios.

Please read the article disclaimer.

Source: Long/Short Funds In A Risk On World